Legislative Guide on Insolvency Guide by afr15630

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									UNCITRAL         UNITED NATIONS COMMISSION ON INTERNATIONAL TRADE LAW




                  Legislative Guide
                 on Insolvency Law




UNITED NATIONS
      The United Nations Commission on International Trade Law (UNCITRAL)
is a subsidiary body of the General Assembly. It prepares international legislative
texts for use by States in modernizing commercial law and non-legislative texts for
use by commercial parties in negotiating transactions. Legislative texts include the
following: United Nations Convention on Contracts for the International Sale of
Goods; Convention on the Limitation Period in the International Sale of Goods;
UNCITRAL Model Law on International Commercial Arbitration; UNCITRAL
Model Law on Procurement of Goods, Construction and Services; United Nations
Convention on Independent Guarantees and Stand-by Letters of Credit;
UNCITRAL Model Law on International Credit Transfers; United Nations Con-
vention on International Bills of Exchange and International Promissory Notes;
United Nations Convention on the Carriage of Goods by Sea, 1978 (Hamburg);
United Nations Convention on the Liability of Operators of Transport Terminals
in International Trade; and UNCITRAL Model Law on Electronic Commerce.
Non-legislative texts include the following: UNCITRAL Arbitration Rules;
UNCITRAL Conciliation Rules; UNCITRAL Notes on Organizing Arbitral Pro-
ceedings; UNCITRAL Legal Guide on Drawing Up International Contracts for the
Construction of Industrial Works; and UNCITRAL Legal Guide on International
Countertrade Transactions.
UNITED NATIONS COMMISSION ON INTERNATIONAL TRADE LAW




                UNCITRAL

         Legislative Guide
        on Insolvency Law




                    UNITED NATIONS
                     New York, 2005
                                    NOTE

     Symbols of United Nations documents are composed of capital letters
combined with figures. Mention of such a symbol indicates a reference to a
United Nations document.

     Material in this publication may be freely quoted or reprinted, but
acknowledgement is requested, together with a copy of the publication contain-
ing the quotation or reprint.




                  UNITED NATIONS PUBLICATION
                        Sales No. E.05.V.10
                       ISBN 92-1-133736-4




                                      ii
                                           Preface
       The Legislative Guide on Insolvency Law was prepared by the United Nations
Commission on International Trade Law (UNCITRAL). The project arose from a proposal
made to the Commission in 1999 that UNCITRAL should undertake further work on insol-
vency law, specifically corporate insolvency, to foster and encourage the adoption of effec-
tive national corporate insolvency regimes. An exploratory meeting to consider the feasi-
bility of such a project was held in December 1999. On the basis of the recommendation
of that meeting, the Commission gave Working Group V (Insolvency Law) a mandate to
prepare a comprehensive statement of key objectives and core features for a strong insol-
vency, debtor-creditor regime, including out-of-court restructuring, and a legislative guide
containing flexible approaches to the implementation of such objectives and features, includ-
ing a discussion of the alternative approaches possible and the perceived benefits and
detriments of such approaches.1 To seek input from the international insolvency community
on the key objectives and the scope of the core features of an insolvency regime to be
included in the Guide, an international colloquium, organized in conjunction with INSOL
International and the International Bar Association, was held in December 2000.

      The first draft of the legislative guide on insolvency law was considered by Working
Group V in July 2001 and work developed through seven one-week sessions, the final
meeting taking place in late March 2004. In addition to representatives of the 36 member
States of the Commission, representatives of many other States and a number of inter-
national organizations, both intergovernmental and non-governmental, participated actively
in the preparatory work. The work was also undertaken in close collaboration with Working
Group VI (Security Interests), to ensure coordination of the treatment of security interests
in insolvency with the legislative guide on secured transactions being developed by
UNCITRAL.

      The final negotiations on the draft legislative guide on insolvency law were held
during the thirty-seventh session of UNCITRAL in New York from 14 to 21 June 2004 and
the text was adopted by consensus on 25 June 2004 (see annex II). Subsequently, the
General Assembly adopted resolution 59/40 of 2 December 2004 (see annex II) in which it
expressed its appreciation to UNCITRAL for completing and adopting the Legislative
Guide.




       1
         Official Records of the General Assembly, Fifty-fifth Session, Supplement No. 17 (A/55/17),
paras. 400-409.

                                                 iii
iv
                                                    Contents

                                                                                                                Page
Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    iii
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        1
      A. Organization and scope of the Legislative Guide . . . . . . . . .                                        1
      B. Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .             3



                                                    Part one
       DESIGNING THE KEY OBJECTIVES AND STRUCTURE OF
         AN EFFECTIVE AND EFFICIENT INSOLVENCY LAW

  I.    Key objectives of an effective and efficient insolvency law . . . .                                       9
        A. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           9
        B. Establishing the key objectives . . . . . . . . . . . . . . . . . . . . . . . .                       10
           1. Provision of certainty in the market to promote economic
               stability and growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                  10
           2. Maximization of value of assets . . . . . . . . . . . . . . . . . . . .                            10
           3. Striking a balance between liquidation and reorganization                                          11
           4. Ensuring equitable treatment of similarly situated
               creditors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         11
           5. Provision for timely, efficient and impartial resolution
               of insolvency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .             12
           6. Preservation of the insolvency estate to allow equitable
               distribution to creditors . . . . . . . . . . . . . . . . . . . . . . . . . . .                   12
           7. Ensuring a transparent and predictable insolvency law
               that contains incentives for gathering and dispensing
               information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .             13
           8. Recognition of existing creditor rights and establishment
               of clear rules for ranking of priority claims . . . . . . . . . . .                               13
           9. Establishment of a framework for cross-border insolvency                                           14
        Recommendations 1-5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                14

        C. Balancing the goals and key objectives of an insolvency law                                           14
        Recommendation 6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .               16

        D. General features of an insolvency law . . . . . . . . . . . . . . . . . .                             16

                                                           v
                                                                                                         Page
          1. Substantive issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           16
          2. The structure of an insolvency law . . . . . . . . . . . . . . . . . .                       17
          3. Relationship between insolvency law and other law . . . .                                    19
       Recommendation 7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         20

II.    Mechanisms for resolving a debtor’s financial difficulties . . . . . .                             21
       A. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    21
       B. Voluntary restructuring negotiations . . . . . . . . . . . . . . . . . . . .                    21
          1. Necessary preconditions . . . . . . . . . . . . . . . . . . . . . . . . . . .                22
          2. Main processes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           23
          3. Rules and guidelines for voluntary restructuring . . . . . . .                               25
       C. Insolvency proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .              26
          1. Reorganization proceedings . . . . . . . . . . . . . . . . . . . . . . . .                   27
          2. Liquidation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        30
       D. Administrative processes . . . . . . . . . . . . . . . . . . . . . . . . . . . . .              32

III.   Institutional framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        33




                                                Part two
                    CORE PROVISIONS FOR AN EFFECTIVE
                     AND EFFICIENT INSOLVENCY LAW

 I.    Application and commencement . . . . . . . . . . . . . . . . . . . . . . . . . .                   38
       A. Eligibility and jurisdiction . . . . . . . . . . . . . . . . . . . . . . . . . . . .            38
          1. Eligibility: debtors to be covered by an insolvency law .                                    38
          2. Jurisdiction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       41
       Recommendations 8-13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           43

       B. Commencement of proceedings . . . . . . . . . . . . . . . . . . . . . . . .                     45
             1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    45
          2. Commencement standards . . . . . . . . . . . . . . . . . . . . . . . . .                     45
          3. Liquidation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        49
          4. Reorganization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           53
          5. Procedural issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .            56
          6. Debtors with insufficient assets . . . . . . . . . . . . . . . . . . . . .                   61
          7. Fees for insolvency proceedings . . . . . . . . . . . . . . . . . . . .                      63
          8. Dismissal of proceedings after commencement . . . . . . . .                                  63
       Recommendations 14-29 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .            64

                                                      vi
                                                                                                          Page
      C.    Applicable law in insolvency proceedings . . . . . . . . . . . .                               67
         1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         67
         2. Law applicable to the validity and effectiveness of
            rights and claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .              68
         3. Law applicable in insolvency proceedings: lex fori
            concursus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          69
         4. Law applicable in insolvency proceedings: exceptions to
            the lex fori concursus . . . . . . . . . . . . . . . . . . . . . . . . . . . . .               69
         5. Achieving a balance between the desirability of
            exceptions and the goals of insolvency . . . . . . . . . . . . . .                             72
      Recommendations 30-34 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .              72

II.   Treatment of assets on commencement of insolvency
      proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    75
      A. Assets constituting the insolvency estate . . . . . . . . . . . . . . . .                         75
          1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        75
          2. Assets included in the insolvency estate . . . . . . . . . . . . . .                          75
          3. Assets excluded from the insolvency estate . . . . . . . . . . .                              80
          4. Time of constitution of the insolvency estate and
             collection of assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .            81
      Recommendations 35-38 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .              82

      B. Protection and preservation of the insolvency estate . . . . . . .                                83
         1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         83
         2. Protection of the estate by application of a stay . . . . . . .                                83
         3. Scope of application of the stay . . . . . . . . . . . . . . . . . . . .                       84
         4. Discretionary or automatic application of the stay . . . . . .                                 88
         5. Time of application of the stay . . . . . . . . . . . . . . . . . . . . .                      89
         6. Duration of application of the stay . . . . . . . . . . . . . . . . . .                        93
         7. Extension of the duration of the stay . . . . . . . . . . . . . . . .                          94
         8. Protection of secured creditors . . . . . . . . . . . . . . . . . . . . .                      94
         9. Limitation on disposal of assets by the debtor . . . . . . . . .                               98
      Recommendations 39-51 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .              99

      C. Use and disposal of assets . . . . . . . . . . . . . . . . . . . . . . . . . . . .               104
         1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        104
         2. Assets of the insolvency estate . . . . . . . . . . . . . . . . . . . . .                     104
         3. Third-party-owned assets . . . . . . . . . . . . . . . . . . . . . . . . . .                  110
         4. Treatment of cash proceeds . . . . . . . . . . . . . . . . . . . . . . . .                    111
      Recommendations 52-62 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .             111

      D. Post-commencement finance . . . . . . . . . . . . . . . . . . . . . . . . . .                    113
         1. Need for post-commencement finance . . . . . . . . . . . . . . .                              113

                                                      vii
                                                                                                            Page
          2. Sources of post-commencement finance . . . . . . . . . . . . . .                               115
          3. Attracting post-commencement finance: providing
             priority or security . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .             115
          4. Authorization for post-commencement finance . . . . . . . .                                    117
          5. Effects of conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                118
       Recommendations 63-68 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .              118

       E. Treatment of contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .              119
          1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         119
          2. Automatic termination, acceleration or similar clauses . .                                     122
          3. Continuation or rejection of contracts . . . . . . . . . . . . . . . .                         123
          4. Leases of land and premises . . . . . . . . . . . . . . . . . . . . . . .                      129
          5. Assignment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           129
          6. General exceptions to the power to continue, reject and
             assign contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           130
          7. Post-commencement contracts . . . . . . . . . . . . . . . . . . . . . .                        131
       Recommendations 69-86 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .              132

       F. Avoidance proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                 135
          1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         135
          2. Avoidance criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .             137
          3. Types of transactions subject to avoidance . . . . . . . . . . .                               141
          4. Transactions exempt from avoidance actions . . . . . . . . . .                                 146
          5. Effect of avoidance: void or voidable transactions . . . . .                                   146
          6. Establishing the suspect period . . . . . . . . . . . . . . . . . . . . .                      147
          7. Conduct of avoidance proceedings . . . . . . . . . . . . . . . . . .                           148
          8. Liability of counterparties to avoided transactions . . . . . .                                151
          9. Conversion of reorganization to liquidation . . . . . . . . . . .                              152
       Recommendations 87-99 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .              152

       G. Rights of set-off . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         155
       Recommendation 100 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .             156

       H. Financial contracts and netting . . . . . . . . . . . . . . . . . . . . . . . .                   156
       Recommendations 101-107 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                158

III.   Participants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   161
       A. The debtor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        161
           1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        161
           2. Continued operation of the debtor’s business and the
               role of the debtor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           161

                                                      viii
                                                                                                       Page
           3. Rights of the debtor . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           166
           4. Obligations of the debtor . . . . . . . . . . . . . . . . . . . . . . . . .              167
           5. Debtor’s liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       171
       Recommendations 108-114 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           171

       B. The insolvency representative . . . . . . . . . . . . . . . . . . . . . . . . .              174
           1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     174
           2. Qualifications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       174
           3. Selection and appointment of the insolvency
              representative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       176
           4. Oversight of the insolvency representative . . . . . . . . . . .                         178
           5. Duties and functions of the insolvency representative . .                                178
           6. Confidentiality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        180
           7. Remuneration of the insolvency representative . . . . . . .                              180
           8. Liability of the insolvency representative . . . . . . . . . . . .                       183
           9. Agents and employees of the insolvency representative                                    185
          10. Review of insolvency representative’s administration . .                                 185
          11. Removal of the insolvency representative . . . . . . . . . . .                           186
          12. Replacement of the insolvency representative . . . . . . . .                             187
       Recommendations 115-125 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           187

       C. Creditors: participation in insolvency proceedings . . . . . . . . .                         190
           1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     190
           2. Extent of involvement of creditors in decision-making .                                  190
           3. Mechanisms to facilitate participation . . . . . . . . . . . . . . .                     194
           4. Creditor meetings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          195
           5. Matters requiring a vote by creditors . . . . . . . . . . . . . . .                      196
           6. Creditor committee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           197
           7. Confidentiality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        202
       Recommendations 126-136 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           202

       D. Party in interest’s right to be heard and to appeal . . . . . . . .                          205
           1. Right to be heard . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          205
           2. Review procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .            205
           3. Right of appeal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        206
       Recommendations 137-138 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           206

       E. Secured creditors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .      207

IV. Reorganization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   209
    A. The reorganization plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .             209
         1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       209

                                                     ix
                                                                                                       Page
            Nature or form of a plan . . . . . . . . . . . . . . . . . . . . . . . . .
            2.                                                                                         209
            Proposal of a reorganization plan . . . . . . . . . . . . . . . . . .
            3.                                                                                         210
            The plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
            4.                                                                                         214
            Approval of a plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
            5.                                                                                         217
            Where a proposed plan cannot be approved . . . . . . . . .
            6.                                                                                         225
            Binding dissenting classes of creditors . . . . . . . . . . . . . .
            7.                                                                                         226
            Court confirmation of a plan . . . . . . . . . . . . . . . . . . . . . .
            8.                                                                                         226
            Effect of an approved and, where required, confirmed
            9.
            plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   229
        10. Challenges to a plan after court confirmation . . . . . . . .                              229
        11. Amendment of a plan after approval by creditors . . . . .                                  230
        12. Implementation of a plan . . . . . . . . . . . . . . . . . . . . . . . . .                 231
        13. Where implementation fails . . . . . . . . . . . . . . . . . . . . . . .                   231
        14. Conversion to liquidation . . . . . . . . . . . . . . . . . . . . . . . . .                232
     Recommendations 139-159 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .             233

     B. Expedited reorganization proceedings . . . . . . . . . . . . . . . . . . .                     238
         1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       238
         2. Creditors typically involved in voluntary restructuring
            negotiations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       239
         3. Proceedings to implement a voluntary restructuring
            agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        240
     Recommendations 160-168 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .             244

V.   Management of proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .             249
     A. Treatment of creditor claims . . . . . . . . . . . . . . . . . . . . . . . . . .               249
         1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       249
         2. Submission of creditor claims . . . . . . . . . . . . . . . . . . . . .                    249
         3. Verification and admission of claims . . . . . . . . . . . . . . .                         256
         4. Claims not admitted . . . . . . . . . . . . . . . . . . . . . . . . . . . . .              263
     Recommendations 169-184 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .             263

     B. Priorities and distribution of proceeds . . . . . . . . . . . . . . . . . .                    266
         1. Priorities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     266
         2. Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       274
     Recommendations 185-193 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .             275

     C. Treatment of corporate groups in insolvency . . . . . . . . . . . . .                          276
         1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       276
         2. Group responsibility for external debts . . . . . . . . . . . . . .                        278
         3. Intra-group debts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .            279

                                                    x
                                                                                                          Page
VI. Conclusion of proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .               281
    A. Discharge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        281
       1. Discharge of the debtor in liquidation . . . . . . . . . . . . . . .                            281
       2. Discharge of debts and claims in reorganization . . . . . . .                                   284
    Recommendations 194-196 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                 284

       B. Closure of proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .              285
          1. Liquidation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        285
          2. Reorganization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           286
       Recommendations 197-198 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .              286

Annexes

 I.    Treatment of secured creditors in insolvency proceedings . . . . . .                               287

II.    Decision of the United Nations Commission on International
       Trade Law and General Assembly Resolution 59/40 . . . . . . . . . .                                289

III.   UNCITRAL Model Law on Cross-Border Insolvency and Guide
       to Enactment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   293




                                                       xi
                                Introduction
        A.    Organization and scope of the Legislative Guide

1. The purpose of the Legislative Guide on Insolvency Law is to assist the
establishment of an efficient and effective legal framework to address the
financial difficulty of debtors. It is intended to be used as a reference by
national authorities and legislative bodies when preparing new laws and regu-
lations or reviewing the adequacy of existing laws and regulations. The advice
provided in the Guide aims at achieving a balance between the need to address
the debtor’s financial difficulty as quickly and efficiently as possible and the
interests of the various parties directly concerned with that financial difficulty,
principally creditors and other parties with a stake in the debtor’s business, as
well as with public policy concerns. The Guide discusses issues central to the
design of an effective and efficient insolvency law, which, despite numerous
differences in policy and legislative treatment, are recognized in many legal
systems. It focuses on insolvency proceedings commenced under the insol-
vency law and conducted in accordance with that law, with an emphasis on
reorganization, against a debtor, whether a legal or natural person, that is
engaged in economic activity. Issues specific to the insolvency of individuals
not so engaged, such as consumers, are not addressed.

2. The Legislative Guide also discusses the increasing use and importance of
other tools for addressing insolvency, specifically restructuring negotiations
entered into voluntarily between a debtor and its key creditors, which are not
regulated by the insolvency law. In addition to addressing the requirements of
domestic insolvency laws, the Guide includes the text and Guide to Enactment
of the UNCITRAL Model Law on Cross-Border Insolvency (the “UNCITRAL
Model Law”) (annex III) to facilitate consideration of cross-border insolvency
issues. It should be noted, however, that a model law generally would be
used differently to a legislative guide. Specifically, a model law is a legislative
text recommended to States for enactment as part of national law, with or
without modification. As such, model laws generally propose a comprehensive
set of legislative solutions to address a particular topic and the language
employed supports direct incorporation of the provisions of the model law into
a national law. The focus of a legislative guide, on the other hand, is upon
providing guidance to legislators and other users and for that reason guides
generally include a substantial commentary discussing and analysing relevant
issues. It is not intended that the recommendations of a legislative guide be
enacted as part of national law as such. Rather, they outline the core issues that
it would be desirable to address in that law, with some recommendations
providing specific guidance on how certain legislative provisions might be
drafted.

                                         1
2                                        UNCITRAL Legislative Guide on Insolvency Law


3. The Legislative Guide does not provide a single set of model solutions to
address the issues central to an effective and efficient insolvency law, but
assists the reader to evaluate different approaches available and to choose the
one most suitable in the national or local context. The first section of each
chapter of the Guide contains a commentary identifying the key issues for
consideration in formulating an insolvency law and discussing and analysing
the various approaches adopted by insolvency laws. The second part of each
chapter contains a set of recommended legislative principles that deals more
specifically with the manner in which those key issues should be addressed in
an insolvency law and includes both a statement of the purpose of including
provisions on a particular topic in an insolvency law and an outline of the
content recommended for inclusion in those provisions. These recommenda-
tions are intended to assist in the establishment of a legislative framework for
insolvency that is both efficient and effective and reflects modern develop-
ments and trends in the area of insolvency. The recommendations adopt
different levels of specificity, depending upon the issue in question. A number
employ legislative language to detail the manner in which a particular issue
should be addressed in an insolvency law, reflecting a high degree of
consensus as to the particular approach to be adopted. Other recommendations
identify key points to be addressed by an insolvency law with respect to a
particular topic and offer possible alternative approaches, indicating the
existence of different policy and procedural concerns that might need to be
considered.


4. The user is advised to read the legislative recommendations together with
the commentary, which provides detailed background information to enhance
understanding of the legislative recommendations, as well as a discussion of
issues not specifically included as recommendations. In view of the key impor-
tance of secured creditors to insolvency proceedings and the policy considera-
tions associated with their treatment under an insolvency law, the user of
this Legislative Guide is also encouraged to consider the work of Working
Group VI (Security Interests) and, when completed, the UNCITRAL legislative
guide on secured transactions.


5. The recommendations included in the Guide do not deal with other areas
of law, although, as discussed throughout the Guide, those other laws have an
impact on both the design of an insolvency law and the conduct of insolvency
proceedings commenced under that law (e.g. part two, chap. I, paras. 80-91,
concerning applicable law, and recommendation 35 (a) pertaining to property
rights of the debtor). Moreover, the successful implementation of an insol-
vency regime requires various measures beyond the establishment of an appro-
priate legislative framework, especially an adequate institutional infrastructure,
organizational capacity, technical professional expertise and appropriate
human and financial resources. Although these matters are discussed in the
commentary, they generally are not addressed in the legislative recommenda-
tions, except where they relate to the insolvency professional appointed to
administer an insolvency estate.
Introduction                                                                  3


                                B.   Glossary
                         1. Notes on terminology
6. The following terms are intended to provide orientation to the reader of the
Legislative Guide. Many terms such as “secured creditor”, “security interest”,
“liquidation” and “reorganization” may have fundamentally different meanings
in different jurisdictions. An explanation of the use of the term in the
Guide may assist in ensuring that the concepts discussed are clear and widely
understood.

(a)   References in the Legislative Guide to the “court”
7. The Legislative Guide assumes that there is reliance on court supervision
throughout the insolvency proceedings, which may include the power to com-
mence insolvency proceedings, to appoint the insolvency representative, to
supervise its activities and to take decisions in the course of the proceedings.
Although this reliance may be appropriate as a general principle, alternatives
may be considered where, for example, the courts are unable to handle insol-
vency work (whether for reasons of lack of resources or lack of requisite
experience) or supervision by some other authority is preferred (see part one,
chap. III, Institutional framework).

8. For purposes of simplicity, the Guide uses the word “court” in the same
way as article 2, subparagraph (e), of the UNCITRAL Model Law on Cross-
Border Insolvency to refer to a judicial or other authority competent to control
or supervise insolvency proceedings. An authority which supports or has speci-
fied roles in insolvency proceedings, but which does not have adjudicative
functions with respect to those proceedings, would not be regarded as within
the meaning of the term “court” as that term is used in the Guide.

(b)   Rules of interpretation
9. “Or” is not intended to be exclusive; use of the singular also includes the
plural; “include” and “including” are not intended to indicate an exhaustive
list; “may” indicates permission and “should” indicates instruction; and “such
as” and “for example” are to be interpreted in the same manner as “include”
or “including”.

10. “Creditors” should be interpreted as including both the creditors in the
forum State and foreign creditors, unless otherwise specified.

11. References to “person” should be interpreted as including both natural
and legal persons, unless otherwise specified.

                         2. Terms and definitions
12. The following paragraphs explain the meaning and use of certain expres-
sions that appear frequently in the Legislative Guide:
4                                                  UNCITRAL Legislative Guide on Insolvency Law


      (a) “Administrative claim or expense”: claims that include costs and
expenses of the proceedings, such as remuneration of the insolvency repre-
sentative and any professionals employed by the insolvency representative,
expenses for the continued operation of the debtor, debts arising from
the exercise of the insolvency representative’s functions and powers, costs
arising from continuing contractual and legal obligations and costs of
proceedings;
      (b) “Assets of the debtor”: property, rights and interests of the debtor,
including rights and interests in property, whether or not in the possession of
the debtor, tangible or intangible, movable or immovable, including the
debtor’s interests in encumbered assets or in third party-owned assets;
      (c) “Avoidance provisions”: provisions of the insolvency law that permit
transactions for the transfer of assets or the undertaking of obligations prior to
insolvency proceedings to be cancelled or otherwise rendered ineffective and
any assets transferred, or their value, to be recovered in the collective interest
of creditors;
      (d) “Burdensome assets”: assets that may have no value or an insignifi-
cant value to the insolvency estate or that are burdened in such a way that
retention would require expenditure that would exceed the proceeds of reali-
zation of the asset or give rise to an onerous obligation or a liability to pay
money;
      (e) “Cash proceeds”: proceeds of the sale of encumbered assets to the
extent that the proceeds are subject to a security interest;
      (f) “Centre of main interests”: the place where the debtor conducts the
administration of its interests on a regular basis and that is therefore ascertain-
able by third parties;1
      (g) “Claim”: a right to payment from the estate of the debtor, whether
arising from a debt, a contract or other type of legal obligation, whether
liquidated or unliquidated, matured or unmatured, disputed or undisputed,
secured or unsecured, fixed or contingent.
Note: Some jurisdictions recognize the ability or right, where permitted by
applicable law, to recover assets from the debtor as a claim;
      (h) “Commencement of proceedings”: the effective date of insolvency
proceedings whether established by statute or a judicial decision;
      (i) “Court”: a judicial or other authority competent to control or super-
vise insolvency proceedings;2
      (j) “Creditor”: a natural or legal person that has a claim against the
debtor that arose on or before the commencement of the insolvency
proceedings;


       1
         European Council Regulation No. 1346/2000 of 29 May 2000 on insolvency proceedings,
recital 13.
       2
         Based on the UNCITRAL Model Law on Cross-Border Insolvency (United Nations publica-
tion, Sales No. E.99.V.3), art. 2, subpara. (e). The text of the Model Law and its Guide to Enactment
are set forth in annex III.
Introduction                                                                                  5


     (k) “Creditor committee”: representative body of creditors appointed in
accordance with the insolvency law, having consultative and other powers as
specified in the insolvency law;
     (l) “Debtor in possession”: a debtor in reorganization proceedings,
which retains full control over the business, with the consequence that the
court does not appoint an insolvency representative;
     (m) “Discharge”: the release of a debtor from claims that were, or could
have been, addressed in the insolvency proceedings;
     (n) “Disposal”: every means of transferring or parting with an asset or
an interest in an asset, whether in whole or in part;
     (o) “Encumbered asset”: an asset in respect of which a creditor has a
security interest;
     (p) “Equity holder”: the holder of issued stock or a similar interest that
represents an ownership claim to a proportion of the capital of a corporation
or other enterprise;
     (q) “Establishment”: any place of operations where the debtor carries out
a non-transitory economic activity with human means and goods or services;3
     (r) “Financial contract”: any spot, forward, future, option or swap trans-
action involving interest rates, commodities, currencies, equities, bonds,
indices or any other financial instrument, any repurchase or securities lending
transaction, and any other transaction similar to any transaction referred to
above entered into in financial markets and any combination of the transactions
mentioned above;4
     (s) “Insolvency”: when a debtor is generally unable to pay its debts as
they mature or when its liabilities exceed the value of its assets;
     (t) “Insolvency estate”: assets of the debtor that are subject to the insol-
vency proceedings;
     (u) “Insolvency proceedings”: collective proceedings, subject to court
supervision, either for reorganization or liquidation;
     (v) “Insolvency representative”: a person or body, including one
appointed on an interim basis, authorized in insolvency proceedings to admi-
nister the reorganization or the liquidation of the insolvency estate;
     (w) “Liquidation”: proceedings to sell and dispose of assets for distribu-
tion to creditors in accordance with the insolvency law;
     (x) “Lex fori concursus”: the law of the State in which the insolvency
proceedings are commenced;
     (y) “Lex rei situs”: the law of the State in which the asset is situated;
     (z) “Netting”: the setting-off of monetary or non-monetary obligations
under financial contracts;


      3
       UNCITRAL Model Law on Cross-Border Insolvency, art. 2, subpara. (f) (see annex III).
      4
       United Nations Convention on the Assignment of Receivables in International Trade (United
Nations publication, Sales No. E.04.V.14), art. 5, subpara. (k).
6                                                UNCITRAL Legislative Guide on Insolvency Law


      (aa) “Netting agreement”: a form of financial contract between two or
more parties that provides for one or more of the following:
               (i) The net settlement of payments due in the same currency on
                   the same date whether by novation or otherwise;
              (ii) Upon the insolvency or other default by a party, the termi-
                   nation of all outstanding transactions at their replacement or
                   fair market values, conversion of such sums into a single
                   currency and netting into a single payment by one party to
                   the other; or
             (iii) The set-off of amounts calculated as set forth in sub-
                   paragraph (ii) of this definition under two or more netting
                   agreements;5
      (bb) “Ordinary course of business”: transactions consistent with both:
(i) the operation of the debtor’s business prior to insolvency proceedings; and
(ii) ordinary business terms;
      (cc) “Pari passu”: the principle according to which similarly situated
creditors are treated and satisfied proportionately to their claim out of the
assets of the estate available for distribution to creditors of their rank;
      (dd) “Party in interest”: any party whose rights, obligations or interests
are affected by insolvency proceedings or particular matters in the insolvency
proceedings, including the debtor, the insolvency representative, a creditor, an
equity holder, a creditor committee, a government authority or any other
person so affected. It is not intended that persons with remote or diffuse
interests affected by the insolvency proceedings would be considered to be a
party in interest;
      (ee) “Post-commencement claim”: a claim arising after commencement
of insolvency proceedings;
      (ff) “Preference”: a transaction which results in a creditor obtaining an
advantage or irregular payment;
      (gg) “Priority”: the right of a claim to rank ahead of another claim where
that right arises by operation of law;
      (hh) “Priority claim”: a claim that will be paid before payment of
general unsecured creditors;
      (ii) “Protection of value”: measures directed at maintaining the eco-
nomic value of encumbered assets and third party owned assets during the
insolvency proceedings (in some jurisdictions referred to as “adequate pro-
tection”). Protection may be provided by way of cash payments, provision of
security interests over alternative or additional assets or by other means as
determined by a court to provide the necessary protection;
      (jj) “Related person”: as to a debtor that is a legal entity, a related
person would include: (i) a person who is or has been in a position of control
of the debtor; and (ii) a parent, subsidiary, partner or affiliate of the debtor. As

      5
       United Nations Convention on the Assignment of Receivables in International Trade, art. 5,
subpara. (l).
Introduction                                                                     7


to a debtor that is a natural person, a related person would include persons who
are related to the debtor by consanguinity or affinity;
      (kk) “Reorganization”: the process by which the financial well-being
and viability of a debtor’s business can be restored and the business continue
to operate, using various means possibly including debt forgiveness, debt
rescheduling, debt-equity conversions and sale of the business (or parts of it)
as a going concern;
      (ll) “Reorganization plan”: a plan by which the financial well-being
and viability of the debtor’s business can be restored;
      (mm) “Sale as a going concern”: the sale or transfer of a business in
whole or substantial part, as opposed to the sale of separate assets of the
business;
      (nn) “Secured claim”: a claim assisted by a security interest taken as a
guarantee for a debt enforceable in case of the debtor’s default;
      (oo) “Secured creditor”: a creditor holding a secured claim;
      (pp) “Security interest”: a right in an asset to secure payment or other
performance of one or more obligations;
      (qq) “Set-off”: where a claim for a sum of money owed to a person is
applied in satisfaction or reduction against a claim by the other party for a sum
of money owed by that first person;
      (rr) “Stay of proceedings”: a measure that prevents the commencement,
or suspends the continuation, of judicial, administrative or other individual
actions concerning the debtor’s assets, rights, obligations or liabilities, includ-
ing actions to make security interests effective against third parties or to
enforce a security interest; and prevents execution against the assets of the
insolvency estate, the termination of a contract with the debtor, and the trans-
fer, encumbrance or other disposition of any assets or rights of the insolvency
estate;
      (ss) “Suspect period”: the period of time by reference to which certain
transactions may be subject to avoidance. The period is generally calculated
retroactively from the date of the application for commencement of insolvency
proceedings or from the date of commencement;
      (tt) “Unsecured creditor”: a creditor without a security interest;
      (uu) “Voluntary restructuring negotiations”: negotiations that are not
regulated by the insolvency law and generally will involve negotiations
between the debtor and some or all of its creditors aiming at a consensual
modification of the claims of participating creditors.
                                Part one
       Designing the key objectives
     and structure of an effective and
         efficient insolvency law
                I. Key objectives of an effective
                   and efficient insolvency law
                              A.    Introduction
1. When a debtor is unable to pay its debts and other liabilities as they
become due, most legal systems provide a legal mechanism to address the
collective satisfaction of the outstanding claims from assets (whether tangible
or intangible) of the debtor. A range of interests needs to be accommodated by
that legal mechanism: those of the parties affected by the proceedings includ-
ing the debtor, the owners and management of the debtor, the creditors who
may be secured to varying degrees (including tax agencies and other govern-
ment creditors), employees, guarantors of debt and suppliers of goods and
services, as well as the legal, commercial and social institutions and practices
that are relevant to the design of the insolvency law and required for its
operation. Generally, the mechanism must strike a balance not only between
the different interests of these stakeholders, but also between these interests
and the relevant social, political and other policy considerations that have an
impact on the economic and legal goals of insolvency proceedings. To the
extent that it is excluded from the scope of such legal mechanisms, a debtor
and its creditors will not be subject to the discipline of the mechanism, nor will
they enjoy the protections provided by the mechanism.

2. Most legal systems contain rules on various types of proceeding (which
are referred to in this Legislative Guide by the generic term “insolvency pro-
ceedings”) that can be initiated to resolve a debtor’s financial difficulties.
While addressing that resolution as a common goal, these proceedings take a
number of different forms for which uniform terminology is not always used
and may include both what might be described as “formal” and “informal”
elements. Formal insolvency proceedings are those commenced under the
insolvency law and governed by that law. They generally include both
liquidation and reorganization proceedings. Informal insolvency processes are
not regulated by the insolvency law and will generally involve voluntary

                                        9
10                                       UNCITRAL Legislative Guide on Insolvency Law


negotiations between the debtor and some or all of its creditors. Often these
types of negotiations have been developed through the banking and commer-
cial sectors and typically provide for some form of restructuring of the insol-
vent debtor. While not regulated by an insolvency law, these voluntary nego-
tiations nevertheless depend for their effectiveness upon the existence of an
insolvency law, which can provide indirect incentives or persuasive force to
achieve reorganization.


                   B.   Establishing the key objectives
3. Although country approaches vary, there is broad agreement that effective
and efficient insolvency regimes should aim to achieve the key objectives
identified below in a balanced manner. Whatever design is chosen for an
insolvency law that will meet these key objectives, the insolvency law must be
complementary to, and compatible with, the legal and social values of the
society in which it is based and which it must ultimately sustain. Although
insolvency law generally forms a distinctive regime, it ought not to produce
results that are fundamentally in conflict with the premises upon which laws
other than the insolvency law are based. Where the insolvency law does seek
to achieve a result that differs or fundamentally departs from that other law
(e.g. with respect to treatment of contracts, avoidance of antecedent acts and
transactions or treatment of the rights of secured creditors), it is highly
desirable that that result be the product of careful consideration and conscious
policy in that direction.

          1.   Provision of certainty in the market to promote
                      economic stability and growth
4. Insolvency laws and institutions are critical to enabling States to achieve
the benefits and avoid the pitfalls of integration of national financial systems
with the international financial system. Those laws and institutions should
promote restructuring of viable business and efficient closure and transfer of
assets of failed businesses, facilitate the provision of finance for start-up and
reorganization of businesses and enable assessment of credit risk, both domes-
tically and internationally. The following key objectives of an insolvency law
should be implemented with a view to enhancing certainty in the market and
promoting economic stability and growth.

                   2.   Maximization of value of assets
5. Participants in insolvency proceedings should have strong incentives to
achieve maximum value for assets, as this will facilitate higher distributions to
creditors as a whole and reduce the burden of insolvency. The achievement of
this goal is often furthered by achieving a balance of the risks allocated be-
tween the parties involved in insolvency proceedings. The manner in which
avoidance provisions treat prior transactions, for example, can ensure that
creditors are treated equitably and enhance the value of the debtor’s assets by
Part one: I. Key objectives of an effective and efficient insolvency law         11


recovering value for the benefit of all creditors. At the same time, the treatment
afforded those transactions can undermine the predictability of contractual
relations that is critical to investment decisions, creating a tension between the
different objectives of an insolvency regime. Similarly, a balance has to be
struck between rapid liquidation and longer-term efforts to reorganize the
business that may generate more value for creditors, between the need for new
investment to preserve or improve the value of assets and the implications and
cost of that new investment on existing stakeholders, and between the different
roles allocated to the different stakeholders, in particular the discretion that can
be exercised by the insolvency representative and the extent to which creditors
can monitor the exercise of that discretion to safeguard the proceedings and
ensure the maximization of value.

     3.    Striking a balance between liquidation and reorganization
6. The first key objective of maximization of value is closely linked to the
balance to be achieved in the insolvency law between liquidation and reorgani-
zation. An insolvency law needs to balance the advantages of near-term debt
collection through liquidation (often the preference of secured creditors)
against preserving the value of the debtor’s business through reorganization
(often the preference of unsecured creditors and the debtor). Achieving that
balance may have implications for other social policy considerations, such as
encouraging the development of an entrepreneurial class and protecting
employment. Insolvency law should include the possibility of reorganization of
the debtor as an alternative to liquidation, where creditors would not involun-
tarily receive less than in liquidation and the value of the debtor to society and
to creditors may be maximized by allowing it to continue. This is predicated
on the basic economic theory that greater value may be obtained from keeping
the essential components of a business together, rather than breaking them up
and disposing of them in fragments. To ensure that insolvency proceedings are
not abused by either creditors or the debtor and that the procedure most appro-
priate to resolution of the debtor’s financial difficulty is available, an insol-
vency law should also provide for conversion between the different types of
proceedings in appropriate circumstances.

    4.    Ensuring equitable treatment of similarly situated creditors
7. The objective of equitable treatment is based on the notion that, in collec-
tive proceedings, creditors with similar legal rights should be treated fairly,
receiving a distribution on their claim in accordance with their relative ranking
and interests. This key objective recognizes that all creditors do not need to be
treated identically, but in a manner that reflects the different bargains they
have struck with the debtor. This is less relevant as a defining factor where
there is no specific debt contract with the debtor, such as in the case of damage
claimants (e.g. for environmental damage) and tax authorities. Even though the
principle of equitable treatment may be modified by social policy on priorities
and give way to the prerogatives pertaining to holders of claims or interests
that arise, for example, by operation of law, it retains its significance by
12                                       UNCITRAL Legislative Guide on Insolvency Law


ensuring that the priority accorded to the claims of a similar class affects all
members of the class in the same manner. The policy of equitable treatment
permeates many aspects of an insolvency law, including the application of the
stay or suspension, provisions to set aside acts and transactions and recapture
value for the insolvency estate, classification of claims, voting procedures in
reorganization and distribution mechanisms. An insolvency law should address
problems of fraud and favouritism that may arise in cases of financial distress
by providing, for example, that acts and transactions detrimental to equitable
treatment of creditors can be avoided.


                  5. Provision for timely, efficient and
                    impartial resolution of insolvency
8. Insolvency should be addressed and resolved in an orderly, quick and
efficient manner, with a view to avoiding undue disruption to the business
activities of the debtor and to minimizing the cost of the proceedings. Achiev-
ing timely and efficient administration will support the objective of maxi-
mizing asset value, while impartiality supports the goal of equitable treatment.
The entire process needs to be carefully considered to ensure maximum effi-
ciency without sacrificing flexibility. At the same time, it should be focused on
the goal of liquidating non-viable and inefficient businesses and the survival
of efficient, potentially viable businesses.

9. Quick and orderly resolution of a debtor’s financial difficulties can be
facilitated by an insolvency law that provides easy access to insolvency pro-
ceedings by reference to clear and objective criteria, provides a convenient
means of identifying, collecting, preserving and recovering assets and rights
that should be applied towards payment of the debts and liabilities of the
debtor, facilitates participation of the debtor and its creditors with the least
possible delay and expense, provides an appropriate structure for supervision
and administration of proceedings (including both professionals and the insti-
tutions involved) and provides, as an end result, effective resolution of the
debtor’s financial obligations and liabilities.


           6.   Preservation of the insolvency estate to allow
                     equitable distribution to creditors
10. An insolvency law should preserve the estate and prevent premature dis-
memberment of the debtor’s assets by individual creditor actions to collect
individual debts. Such activity often reduces the total value of the pool of
assets available to settle all claims against the debtor and may preclude
reorganization or the sale of the business as a going concern. A stay of creditor
action provides a breathing space for debtors, enabling a proper examination
of its financial situation and facilitating both maximization of the value of the
estate and equitable treatment of creditors. Some mechanism may be required
to ensure that the stay does not affect the rights of secured creditors.
Part one: I. Key objectives of an effective and efficient insolvency law                             13


        7.    Ensuring a transparent and predictable insolvency law
                    that contains incentives for gathering and
                              dispensing information
11. An insolvency law should be transparent and predictable. This will enable
potential lenders and creditors to understand how insolvency proceedings
operate and to assess the risk associated with their position as a creditor in the
event of insolvency. This will promote stability in commercial relations and
foster lending and investment at lower risk premiums. Transparency and pre-
dictability will also enable creditors to clarify priorities, prevent disputes by
providing a backdrop against which relative rights and risks can be assessed
and help define the limits of any discretion. Unpredictable application of the
insolvency law has the potential to undermine not only the confidence of all
participants in insolvency proceedings, but also their willingness to make
credit and other investment decisions prior to insolvency. As far as possible,
an insolvency law should clearly indicate all provisions of other laws that may
affect the conduct of the insolvency proceedings (e.g. labour law; commercial
and contract law; tax law; laws affecting foreign exchange, netting and set-off
and debt for equity swaps; and even family and matrimonial law).

12. An insolvency law should ensure that adequate information is available in
respect of the debtor’s situation, providing incentives to encourage the debtor
to reveal its positions and, where appropriate, sanctions for failure to do so.
The availability of this information will enable those responsible for adminis-
tering and supervising insolvency proceedings (courts or administrative
agencies, the insolvency representative) and creditors to assess the financial
situation of the debtor and determine the most appropriate solution.


      8.     Recognition of existing creditor rights and establishment
                  of clear rules for ranking of priority claims
13. Recognition and enforcement in insolvency proceedings of the differing
rights that creditors had with respect to the debtor and its assets before the
commencement of insolvency proceedings will create certainty in the market
and facilitate the provision of credit, in particular with respect to the rights and
priorities of secured creditors. Clear rules for the ranking of priorities of both
existing and post-commencement creditor claims are important to provide pre-
dictability to lenders, and to ensure consistent application of the rules, confi-
dence in the proceedings and that all participants are able to adopt appropriate
measures to manage risk. To the greatest extent possible,1 those priorities
should be based upon commercial bargains and not reflect social and political
concerns that have the potential to distort the outcome of insolvency. Accord-
ing priority to claims that are not based on commercial bargains therefore
should be minimized.

      1
        The priority of claims under an insolvency law may be affected by a State’s international treaty
obligations (see the discussion on priorities in part two, chap. V, paras. 67-74).
14                                            UNCITRAL Legislative Guide on Insolvency Law


      9.     Establishment of a framework for cross-border insolvency
14. To promote coordination between jurisdictions and facilitate the provision
of assistance in the administration of insolvency proceedings originating in a
foreign country, insolvency laws should provide rules on cross-border insol-
vency, including the recognition of foreign proceedings, by adopting the
UNCITRAL Model Law on Cross-Border Insolvency (see annex III).


                        Recommendations 1-5 (paras. 4-14)

           1. In order to establish and develop an effective insolvency law, the
      following key objectives should be considered:
           (a) Provide certainty in the market to promote economic stability and
      growth;
           (b) Maximize value of assets;
           (c) Strike a balance between liquidation and reorganization;
           (d) Ensure equitable treatment of similarly situated creditors;
           (e) Provide for timely, efficient and impartial resolution of insolvency;
           (f) Preserve the insolvency estate to allow equitable distribution to
      creditors;
           (g) Ensure a transparent and predictable insolvency law that contains
      incentives for gathering and dispensing information; and
           (h) Recognize existing creditors rights and establish clear rules for rank-
      ing of priority claims.
           2. The insolvency law should include provisions addressing both
      reorganization and liquidation of a debtor.
          3. The insolvency law should recognize rights and claims arising under
      law other than the insolvency law, whether domestic or foreign, except to the
      extent of any express limitation set forth in the insolvency law.
           4. The insolvency law should specify that where a security interest is
      effective and enforceable under law other than the insolvency law, it will be
      recognized in insolvency proceedings as effective and enforceable.
          5. The insolvency law should include a modern, harmonized and fair
      framework to address effectively instances of cross-border insolvency.
      Enactment of the UNCITRAL Model Law on Cross-Border Insolvency is
      recommended.



 C.        Balancing the goals and key objectives of an insolvency law
15. Since an insolvency regime cannot fully protect the interests of all parties,
some of the key policy choices to be made when designing an insolvency
law relate to defining the broad goals of the law (rescuing businesses in finan-
cial difficulty, protecting employment, protecting the interests of creditors,
Part one: I. Key objectives of an effective and efficient insolvency law                             15


encouraging the development of an entrepreneurial class) and achieving the
desired balance between the specific objectives identified above. Insolvency
laws achieve that balance by reapportioning the risks of insolvency in a way
that suits a State’s economic, social and political goals. As such, an insolvency
law can have widespread effects in the broader economy.
16. The achievement of that balance in the insolvency law and the integration
of the law with the wider legal regime are vital to maintaining social order and
stability. All parties need to be able to anticipate how their legal rights will be
affected in the event of a debtor’s inability to pay, or to pay in full, what is
owed to them. This allows both creditors and equity investors to calculate the
economic implications of default by the debtor and so estimate their risks.
These issues are discussed in detail throughout the Legislative Guide.
17. There is no universal solution to the design of an insolvency law because
States vary significantly in their needs, as do their laws on other issues of key
importance to insolvency, such as security interests,2 property and contract
rights, remedies and enforcement procedures. Although there may be no uni-
versal solution, most insolvency laws address the range of issues raised by the
key objectives discussed above, albeit with different emphasis and focus. Some
laws favour stronger recognition and enforcement of creditor rights and com-
mercial bargains in insolvency and give creditors more control over the con-
duct of insolvency proceedings than the debtor (sometimes referred to as
“creditor-friendly” regimes). Other laws lean towards giving the debtor more
control over the proceedings (referred to as “debtor-friendly” regimes), while
yet others seek to strike a balance in the middle. Some laws give more promi-
nence to liquidation of the debtor in order to weed out inefficient and incom-
petent market players, while others favour reorganization. The focus on
reorganization may serve a number of different aims, such as enhancing the
value of creditors’ claims as part of an ongoing business concern, providing a
second chance to the shareholders and management of the debtor; providing
strong incentives for the adoption by entrepreneurs and managers of appro-
priate attitudes to risk; or protecting vulnerable groups, such as the debtor’s
employees, from the effects of business failure.3 Some laws give particular
emphasis to the protection of employees and the maintenance of employment
in insolvency, while others provide that business can be downsized with
minimum protections afforded to employees.
18. Nevertheless, adopting a reorganization-friendly approach should not
result in establishing a safe haven for moribund enterprises: enterprises that are

       2
         Steps have been taken in recent years towards harmonizing the law on security interests, such
as the United Nations Convention on the Assignment of Receivables in International Trade, the
Unidroit Convention on International Interests in Mobile Equipment (Cape Town, 2001) and work by
UNCITRAL to develop a legislative guide on secured transactions.
       3
         There is not necessarily a direct correlation between the debtor or creditor friendliness of an
insolvency regime, the emphasis on liquidation or reorganization and the subsequent success or failure
of reorganization. While it is beyond the scope of the Guide to discuss these issues in any detail, they
are important for the design of an insolvency regime and deserve consideration. While the rate of
successful reorganizations varies considerably between those regimes classified as creditor-friendly,
research appears to suggest that the assumption that creditor-friendly regimes lead to fewer or less
successful reorganizations than debtor-friendly regimes is not necessarily true.
16                                          UNCITRAL Legislative Guide on Insolvency Law


beyond rescue should be liquidated as quickly and efficiently as possible. To
the extent that some interests may be regarded as being of lower priority than
others, the establishment of mechanisms outside of the insolvency law may
provide a better solution than trying to address those interests under the insol-
vency regime. For example, where as a matter of policy it is decided that
employee claims should rank lower than secured and priority creditors in
insolvency, insurance arrangements can be used to protect employee entitle-
ments (see below, part two, chap. V, paras. 72 and 73).

19. Because society is constantly evolving, insolvency law cannot be static,
but requires reappraisal at regular intervals to ensure that it meets current social
needs. Responses to perceived social change involve an act of judgement that
can be informed by international best practice. Such practice can then be
transposed into national insolvency regimes, taking into account the realities of
the system and available human and material resources.


                        Recommendation 6 (paras. 15-19)

     6. The recommendations in the Legislative Guide have been designed to
     address each of the key objectives and achieve an appropriate balance between
     them.




                D.   General features of an insolvency law
                              1.   Substantive issues
20. Designing an effective and efficient insolvency law involves the consi-
deration of a common set of issues relating to the substantive and procedural
legal framework and the institutional framework required for its implementa-
tion. The substantive issues, which are discussed in detail in part two of the
Legislative Guide, include:
     (a) Identifying the debtors that may be subject to insolvency proceed-
ings, including those debtors which may require a special insolvency regime;
     (b) Determining when insolvency proceedings may be commenced and
the type of proceeding that may be commenced, the party that may request
commencement and whether the commencement criteria should differ depend-
ing upon the party requesting commencement;
     (c) The extent to which the debtor should be allowed to retain control of
the business once insolvency proceedings commence or be displaced and an
independent party (referred to in the Guide as the “insolvency representative”)
appointed to supervise and manage the debtor, and the distinction to be made
between liquidation and reorganization in that regard;
     (d) Identification of the assets of the debtor that will be subject to the
insolvency proceedings and constitute the insolvency estate;
Part one: I. Key objectives of an effective and efficient insolvency law       17


     (e) Protection of the insolvency estate against the actions of creditors,
the debtor itself and the insolvency representative and, where the protective
measures apply to secured creditors, the manner in which the economic value
of the security interest will be protected during the insolvency proceedings;
     (f) The manner in which the insolvency representative may deal with
contracts entered into by the debtor before the commencement of proceedings
and in respect of which both the debtor and its counterparty have not fully
performed their respective obligations;
     (g) The extent to which set-off or netting rights can be enforced or
will be protected, notwithstanding the commencement of the insolvency
proceedings;
     (h) The manner in which the insolvency representative may use or dis-
pose of assets of the insolvency estate;
     (i) The extent to which the insolvency representative can avoid certain
types of transaction that result in the interests of creditors being prejudiced;
     (j) In the case of reorganization, preparation of the reorganization
plan and the limitations, if any, that will be imposed on the content of the plan,
the preparer of the plan and the conditions required for its approval and
implementation;
     (k) Rights and obligations of the debtor;
     (l) Duties and functions of the insolvency representative;
     (m) Functions of the creditors and creditor committee;
     (n) Costs and expenses relating to the insolvency proceedings;
     (o) The treatment of claims and their ranking for the purposes of distri-
buting the proceeds of liquidation;
     (p) Distribution of the proceeds of liquidation;
     (q) Discharge or dissolution of the debtor; and
     (r) Conclusion of the proceedings.

                     2.    The structure of an insolvency law
21. In addition to consideration of these substantive issues, an insolvency law
will need to consider the structure of the procedure that leads to the choice of
reorganization or liquidation proceedings. Approaches differ widely. Some
insolvency laws provide for unitary, flexible insolvency proceedings with a
single commencement requirement alternatively resulting in reorganization or
liquidation, depending on the circumstances of the case. Other laws provide for
two distinct proceedings, each setting forth its own access and commencement
requirements, with different possibilities for conversion between the two pro-
ceedings. The laws that treat reorganization and liquidation proceedings as
distinct from one another do so on the basis of different social and commercial
policy considerations. However, a significant number of issues are common to
both reorganization and liquidation, resulting in considerable overlaps and
linkages between them, in terms of both procedural steps and substantive
issues, as will become evident from the discussion in part two, which follows.
18                                       UNCITRAL Legislative Guide on Insolvency Law


22. The determination of whether the business of the insolvent debtor is
viable should determine, at least in theory, which proceedings will be sought.
As a matter of practice, however, at the time of commencement of either
reorganization or liquidation, it is often impossible to make a final evaluation
as to the financial viability of the business. Some of the disadvantages of an
approach that requires a decision to be made between the different proceedings
at the time of commencement are that it may create an undesirable degree of
polarization between reorganization and liquidation and can result in delay,
increased expense and inefficiency, especially, for example, where the failure
of reorganization requires a new and separate application to be made for
liquidation. This inefficiency can be overcome, to some extent, by providing
linkages between the two proceedings, with a view to allowing conversion of
one type of proceeding to the other in certain specific circumstances, and by
including devices designed to prevent the abuse of insolvency proceedings,
such as commencing reorganization proceedings as a means of avoiding or
delaying liquidation.

23. As to the question of choice between proceedings, some States provide
that the party applying for the insolvency proceedings will have the initial
choice between liquidation and reorganization. When liquidation proceedings
are initiated by one or more creditors, the law will often provide a mechanism
that enables the debtor to request conversion into reorganization proceedings
where feasible. When the debtor applies for reorganization proceedings,
whether on its own motion or as a consequence of an application for liquida-
tion by a creditor, the application for reorganization should logically be
decided first. With a view to protecting creditors, however, some insolvency
laws provide a mechanism enabling reorganization to be converted into liqui-
dation upon a determination, either at an early stage of the proceedings or later,
that reorganization is not likely to, or cannot, succeed. Another mechanism for
protection of creditors may consist of setting forth the maximum period for
which reorganization against the will of the creditors could be continued.

24. As a general principle, although usually presented as separate, liquidation
and reorganization proceedings are normally carried out sequentially; that is,
liquidation proceedings will only run their course if reorganization is unlikely
to be successful or if reorganization efforts have failed. In some insolvency
systems, the general presumption is that a business should be reorganized and
liquidation proceedings may be commenced only when all attempts to reorga-
nize the entity have failed. In insolvency systems providing for conversion, a
request for reorganization to be converted into liquidation may be made by the
debtor, the creditors or the insolvency representative, depending upon the
provisions of the law. These circumstances may include where the debtor is
unable to pay post-petition debts as they fall due; where the reorganization
plan is not approved by creditors or the court; where the debtor fails to fulfil
its obligations under an approved plan; or where the debtor attempts to defraud
creditors. While it is often possible for reorganization proceedings to be con-
verted to liquidation proceedings, most insolvency systems do not allow recon-
version to reorganization once conversion of reorganization to liquidation has
already occurred.
Part one: I. Key objectives of an effective and efficient insolvency law                   19


25. Difficulties of determining at the very outset whether the debtor should be
liquidated rather than reorganized have led some States to revise their insol-
vency laws by replacing separate proceedings with “unitary” proceedings.4
Under the “unitary” approach there is an initial period (usually referred to as
an “observation period”, which in existing examples of unitary laws may last
up to three months) during which no presumption is made as to whether the
business will be eventually reorganized or liquidated. The choice between
reorganization and liquidation proceedings only occurs once the financial
situation of the debtor has been assessed and a determination made as to
whether reorganization is actually possible. The basic advantages offered by
this approach are its procedural simplicity, its flexibility and possible cost
efficiency. Simple, unitary proceedings may also encourage early recourse to
the proceedings by debtors facing financial difficulties, thus enhancing the
chances of successful reorganization. A disadvantage of the approach, how-
ever, may be the delay that occurs between the decision to commence and the
decision as to which proceedings should be followed, and the consequences for
the debtor’s business and the value of its assets that may flow from that delay.
However the insolvency law is arranged in terms of reorganization and liqui-
dation, it should ensure that, once a debtor is in the system, it cannot exit
without some final determination of its future.


          3.    Relationship between insolvency law and other law
26. A more general issue to be considered is how an insolvency law will
relate to other substantive laws and whether the insolvency law will effectively
modify those laws. Relevant laws may include labour laws that provide certain
protections to employees, laws that limit the availability of set-off and netting,
laws that limit debt-for-equity conversions and laws that impose foreign
exchange and foreign investment controls that could affect the content of a
reorganization plan (see labour contracts, part two, chaps. II, para. 145, and V,
paras. 72 and 73; set-off and netting, part two, chap. II, paras. 204-215; and
content of a reorganization plan, part two, chap. IV, paras. 18-22). The rela-
tionship between insolvency law and other laws should be clear and, where
possible, references to the other laws should be included in the insolvency law.

27. While the institutional framework is not discussed in any detail in the
Legislative Guide, some of the issues are touched upon below. Notwithstand-
ing the variety of substantive issues that must be resolved, insolvency laws are
highly procedural in nature. The design of the procedural rules plays a critical
role in determining how roles are to be allocated between the various partici-
pants, in particular in terms of decision-making. To the extent that the insol-
vency law places considerable responsibility upon the institutional infrastruc-
ture to make key decisions, it is essential that that infrastructure be sufficiently
developed to enable the required decisions to be made.


     4
       Where a unitary system is chosen, some changes will need to be made to the various core
elements of the insolvency law.
20                                            UNCITRAL Legislative Guide on Insolvency Law




                           Recommendation 7 (para. 20)

         7. In order to design an effective and efficient insolvency law, the fol-
     lowing common features should be considered:
          (a) Identifying the debtors that may be subject to insolvency proceed-
     ings, including those debtors which may require a special insolvency regime;
          (b) Determining when insolvency proceedings may be commenced and
     the type of proceeding that may be commenced, the party that may request
     commencement and whether the commencement criteria should differ depend-
     ing upon the party requesting commencement;
          (c) The extent to which the debtor should be allowed to retain control of
     the business once insolvency proceedings commence or be displaced and an
     independent party (in the Legislative Guide referred to as the “insolvency
     representative”) appointed to supervise and manage the debtor, and the distinc-
     tion to be made between liquidation and reorganization in that regard;
          (d) Identification of the assets of the debtor that will be subject to the
     insolvency proceedings and constitute the insolvency estate;
          (e) Protection of the insolvency estate against the actions of creditors,
     the debtor itself and the insolvency representative and, where the protective
     measures apply to secured creditors, the manner in which the economic value
     of the security interest will be protected during the insolvency proceedings;
          (f) The manner in which the insolvency representative may deal with
     contracts entered into by the debtor before the commencement of proceedings
     and in respect of which both the debtor and its counterparty have not fully
     performed their respective obligations;
         (g) The extent to which set-off or netting rights can be enforced or will
     be protected, notwithstanding the commencement of insolvency proceedings;
         (h) The manner in which the insolvency representative may use or dis-
     pose of assets of the insolvency estate;
         (i) The extent to which the insolvency representative can avoid certain
     types of transaction that result in the interests of creditors being prejudiced;
          (j) In the case of reorganization, preparation of the reorganization
     plan and the limitations, if any, that will be imposed on the content of the plan,
     the preparer of the plan and the conditions required for its approval and
     implementation;
         (k) Rights and obligations of the debtor;
         (l) Duties and functions of the insolvency representative;
         (m) Functions of the creditors and creditor committee;
         (n) Costs and expenses relating to the insolvency proceedings;
          (o) The treatment of claims and their ranking for the purposes of distri-
     buting the proceeds of liquidation;
         (p) Distribution of the proceeds of liquidation;
         (q) Discharge or dissolution of the debtor; and
         (r) Conclusion of the proceedings.
                II. Mechanisms for resolving a
                  debtor’s financial difficulties
                              A.   Introduction
1. The following discussion focuses upon different mechanisms that have
been developed for resolving a debtor’s financial difficulties and have proved
to be useful tools for addressing those difficulties. These include proceedings
conducted under the insolvency law, whether reorganization or liquidation;
negotiations with creditors entered into by the debtor on a voluntary basis and
conducted essentially outside the insolvency law; and administrative pro-
cedures that have been developed in a number of countries to address, specifi-
cally, systemic financial problems in the banking sector. The latter have been
included simply for information and it is not suggested that they should be
developed to address the insolvency of debtors engaged in economic activity.
Similarly, the facilitating agency used to supervise these particular administra-
tive procedures should not be confused with the authorities that might be
developed to supervise insolvency proceedings conducted under the insol-
vency law in respect of economic debtors that are contemplated by the use of
the term “court” in the Legislative Guide.

               B.   Voluntary restructuring negotiations
2. Voluntary restructuring negotiations were developed some years ago by
the banking sector, as an alternative to formal reorganization proceedings
under the insolvency law. Led and influenced by internationally active banks
and financiers, this type of negotiation has gradually spread to a considerable
number of jurisdictions, although use of them varies—in some jurisdictions
they are, reportedly, rarely used, while in others most reorganization is
reported to be conducted by way of such negotiations. To some extent these
results may reflect the existence (or not) of what is sometimes described as a
“rescue culture”—the degree to which participants regard this type of negotia-
tion as likely to be successful, irrespective of the formal absence of features
of proceedings conducted under the insolvency law, such as a stay of creditor
actions.

3. The use of voluntary restructuring negotiations has generally been limited
to cases of corporate financial difficulty or insolvency in which there is a
significant amount of debt owed to banks and financiers. The negotiations are
aimed at securing contractual arrangements both between the lenders them-
selves and the lenders and the debtor for the restructuring of the debtor, with
or without rearrangement of the financing. This can provide a means of intro-
ducing flexibility into an insolvency regime by reducing the burden on judicial

                                       21
22                                                  UNCITRAL Legislative Guide on Insolvency Law


infrastructure, facilitating an earlier proactive response from creditors than
would normally be possible under formal insolvency proceedings and avoiding
the stigma that often attaches to insolvency. While not based or reliant upon
the provisions of the insolvency law, use of this type of negotiation depends
very largely for its success upon the existence and availability of an effective
and efficient insolvency law and supporting institutional framework1 to provide
sanctions that can assist to make the voluntary negotiations successful. Unless
the debtor and its bank and financial creditors take the opportunity to join
together and voluntarily enter into these negotiations, the debtor or the credi-
tors can invoke the insolvency law, with some potential for detriment to both
the debtor and its creditors in terms of delay, cost and outcome.

4. Many legal systems contemplate that a debtor can enter into agreements or
arrangements designed to restructure it or its debt with some of all of its
creditors that may be governed not by the insolvency law but by, for example,
contract law, company or commercial law or civil procedural law, or in some
cases relevant banking regulations. However, there are a few jurisdictions that
do not allow such agreements or arrangements to occur outside of the court
system or the insolvency law. Some laws would regard the steps associated
with such voluntary restructuring negotiations as sufficient for the courts to
make a declaration of insolvency. Similarly, there are a number of jurisdictions
that, because they impose on the debtor an obligation to commence formal
insolvency proceedings within a certain time after a defined event of insol-
vency, restrict the conduct of such voluntary negotiations to circumstances
where the formal conditions for commencement of proceedings have not been
met. Notwithstanding these limitations, it is suggested that banks and other
creditors in these jurisdictions often use various techniques to achieve some
form of reorganization of debtors outside the insolvency law.

                               1.    Necessary preconditions
5. Voluntary restructuring negotiations depend for their effectiveness on a
number of well-defined initial premises. These may include:
     (a) A significant amount of debt owed to a number of main banks or
financial institution creditors;
     (b) The present or imminent inability of the debtor to service that debt;
     (c) Acceptance of the view that it may be preferable to negotiate an
arrangement, as between the debtor and the financiers and also between the
financiers themselves, to resolve the financial difficulties of the debtor;
     (d) The use of relatively sophisticated refinancing, security and other
commercial techniques that might be employed to alter, rearrange or restruc-
ture the debts of the debtor or the debtor itself;
     (e) The sanction that if the negotiation process cannot be started or
breaks down there can be swift and effective resort to the insolvency law;

     1
         See the discussion of institutional framework in chap. III below.
Part one:   II. Mechanisms for resolving a debtor’s financial difficulties      23


     (f) The prospect that there may be a greater benefit for all parties
through the negotiation process than by direct and immediate resort to the
insolvency law (in part because the outcome is subject to the control of the
negotiating parties and the process is less expensive and can be accomplished
quickly without disrupting the debtor’s business);
     (g) The debtor does not need relief from trade debts, or the benefits of
formal insolvency, such as the automatic stay or the ability to reject burden-
some debts; and
     (h) Favourable or neutral tax treatment for reorganization both in the
debtor’s jurisdiction and the jurisdictions of foreign creditors.

                                    2.    Main processes
6. To be effective, voluntary restructuring negotiations require a number of
different steps to be followed and a range of skills to be employed. The main
elements in the process are discussed below.

(a)   Commencing the negotiations
7. Voluntary negotiations essentially involve bringing together the debtor
and creditors, or at least the main creditors, one or more of whom must initiate
the negotiations (as there can be no reliance upon a law or a facilitator for
initiation, imposition or assistance of the negotiations). A debtor might be
unwilling to commence a dialogue with creditors or at least with all of its
creditors and creditors, while concerned for their own position, may have little
interest in collective negotiations. It is at this point that the availability and
effectiveness of individual creditor remedies or formal insolvency proceedings
can be used to encourage the commencement and progress of such negotia-
tions. A debtor who remains reluctant to participate may find itself subject to
individual debt or enforcement actions or even insolvency proceedings, which
it will not be able to defeat or delay. At the same time, creditors may also find
themselves subject to formal insolvency proceedings that effectively prevent
them from enforcing their individual rights and might not represent the optimal
process for recovery of their debt. Creating a forum in which the debtor and
creditors can come together to explore and negotiate an arrangement to deal
with the debtor’s financial difficulty is therefore crucial.

(b)   Coordinating participants: appointing a lead creditor
      and steering committee
8. The voluntary negotiations would need to involve all key constituencies;
generally the lenders’ group and sometimes key creditor constituencies that
may be affected by a voluntary restructuring agreement are critical to the
negotiations. To better coordinate negotiations, a principal creditor is often
appointed to provide leadership, organization, management and administration.
This creditor typically reports to a committee that is representative of all credi-
tors (a steering committee) and can provide assistance and act as a sounding
board for proposals regarding the debtor.
24                                                   UNCITRAL Legislative Guide on Insolvency Law


(c)   Agreeing to a “standstill”
9. To allow business operations to continue and to ensure that sufficient time
is available to obtain and evaluate information about the debtor and formulate
and assess proposals to resolve the debtor’s financial difficulties, a contractual
agreement to suspend adverse actions by both the debtor and the main creditors
may be required. That agreement would generally need to endure for a defined,
usually short period, unless inappropriate in a particular case.

(d)   Engaging advisors
10. Few, if any, attempts are made at voluntary restructuring without the
involvement of independent experts and advisors from various disciplines
(e.g. legal, accounting, finance and business regulation or marketing). While it
may be suggested that such involvement will lead to unnecessary cost and
intrusion into the affairs of the debtor and creditors, as well as a loss of control, it
is generally necessary to ensure the provision of information, independently
verified, as well as professionally developed plans for refinancing, restructuring,
management and operation that are essential to the success of these negotiations.

(e)   Ensuring adequate cash flow and liquidity
11. A debtor that becomes a candidate for voluntary restructuring negotiations
will often require continued access to established lines of credit or the pro-
vision of fresh credit. Provision of credit by existing secured creditors may not
present a problem. Where this is not available, however, and fresh credit is
required, there may be difficulties in guaranteeing the eventual repayment
of the fresh credit if the negotiations fail. While this issue can be addressed
under the insolvency law by providing some form of priority or security for
such ongoing lending (see part two, chap. II, paras. 100-104), the insolvency
law will not generally extend to an agreement reached by way of voluntary
negotiations.

12. Those creditors who participate in voluntary negotiations can nevertheless
agree among themselves that if one or more of them extends further credit the
others will subordinate their claims to enable the new credit to be repaid ahead
of their own claims. Thus, as between those creditors, there will be a contrac-
tual agreement for the repayment of new money where the restructuring nego-
tiations are successful. Where the negotiations fail, however, and the debtor is
liquidated, the creditor who has provided the fresh credit may be left with an
unsecured claim (unless a security interest was provided) and receive only
partial repayment along with other unsecured creditors.2

(f)   Access to information on the debtor
13. Access to complete, accurate information on the debtor is essential to
enable proper evaluation to be made of its financial position and proposals to

      2
          See part two, chap. V, paras. 55-61, on subordination of claims.
Part one:   II. Mechanisms for resolving a debtor’s financial difficulties     25


be made to relevant creditors. Information concerning the assets, liabilities and
business of the debtor will need to be made available to all relevant creditors
but that information, unless already publicly available, may need to be treated
as confidential.

(g)   Dealing with creditors
14. The complexity of the interests of creditors often presents critical problems
for voluntary negotiations. Providing for these differing interests, and per-
suading those creditors which have already commenced recovery or enforce-
ment action against the debtor that they should participate in the negotiations
may be possible only if there is a prospect of a better result through those
negotiations or if the threat of formal insolvency proceedings will restrain
creditors from pursuing their individual rights.

15. In many cases, however, it will not be possible (or indeed necessary) to
involve every creditor in the negotiations, either because of their number and
diverse interests or because of the inefficiency of involving creditors who are
owed only small amounts of money or who do not have the commercial
expertise, knowledge or will to participate effectively. While creditors who fall
into these categories may often be left out of the negotiations, they cannot be
ignored, as they may be important to the continued operation of the business
(as suppliers of essential goods or services or as participants in essential parts
of the debtor’s production process) and there are no rules that can compel such
creditors to accept the decision of a majority of their number.

16. In a voluntary restructuring agreement, trade and small creditors often
recover payment in full. Although this suggests unequal treatment, it may
make commercial sense to a group of major creditors. An alternative approach
is to secure agreement of the main creditors to a restructuring plan and then
use the plan as the basis of a formal court supervised reorganization proceed-
ings in which other creditors participate (sometimes referred to as a “pre-
packaged” plan and in this Guide as “expedited reorganization proceedings”—
see part two, chap. IV, paras. 76-94). This plan can then bind the other
creditors. Without an effective formal insolvency regime, this result could not
be achieved in those circumstances.

            3. Rules and guidelines for voluntary restructuring
17. To assist the conduct of voluntary restructuring negotiations, and in par-
ticular to address the problems noted above in the context of complex, multi-
national businesses, a number of organizations have developed non-binding
principles and guidelines. One such approach is called the “London approach”,
which can be summarized as an informal framework introduced with the sup-
port of the Bank of England for dealing with temporary support operations
mounted by banks and other lenders to a company or group in financial dif-
ficulties, pending a possible restructuring. The approach urges commercial
banks to take a supportive attitude toward their debtors that are in financial
26                                        UNCITRAL Legislative Guide on Insolvency Law


difficulties. Decisions about the debtor’s longer-term future should be made
only on the basis of comprehensive information, which is shared between all
the banks and other parties that would be involved in any agreement as to the
future of the debtor. Interim financing is facilitated by a standstill and sub-
ordination agreement and banks work together with other creditors to reach a
collective view on whether and on what terms a debtor entity should be given
a financial lifeline. Similar approaches, and in some cases guidelines, have
been developed by the central banks of other countries.

18. An international organization that has undertaken work in this area is
INSOL International, which has published a Statement of Principles for a
Global Approach to Multi-Creditor Workouts. The Principles are designed to
expedite voluntary restructuring negotiations and increase the prospects of
success by providing guidance to diverse creditor groups about how to proceed
on the basis of some common agreed rules.


                        C.    Insolvency proceedings
19. Two main types of proceedings are common to the majority of insolvency
laws: reorganization and liquidation.

20. The traditional division or distinction between these two types of proceed-
ing can be somewhat artificial and can create unnecessary polarization and
inflexibility. It does not accommodate, for example, cases not easily situated
at the poles those cases where a flexible approach to the debtor’s financial
situation is likely to achieve the best result for both the debtor and the creditors
in terms of maximizing the value of the insolvency estate. For example, the
term “reorganization” is sometimes used to refer to a particular way of ensur-
ing preservation and possible enhancement of the value of the insolvency
estate in the context of liquidation proceedings, such as where the law provides
for liquidation to be carried out by transferring the business to another entity
as a going concern. In that situation, the term “reorganization” merely points
to a technique other than traditional liquidation (i.e. straightforward, piecemeal
sale or realization of the assets) being used in order to obtain as much value
as possible from the insolvency estate. To achieve such a sale or realization,
the insolvency law may need to include an element of flexibility not generally
available in laws that define liquidation as a sale of assets as soon as possible
and allow the business to be continued only for that purpose. Some laws, for
example, actually provide the power for the insolvency representative to effect
a more advantageous sale or realization of the debtor’s assets than would be
affected in liquidation. Similarly, reorganization may require the sale of sig-
nificant parts of the debtor’s business or contemplate an eventual liquidation
or sale of the business to a new company and the dissolution of the existing
debtor.

21. For these reasons, it is desirable that an insolvency law provide more than
a choice between a single, narrowly defined type of reorganization and strictly
traditional liquidation. Since the concept of reorganization can accommodate a
Part one:   II. Mechanisms for resolving a debtor’s financial difficulties     27


variety of arrangements, it is desirable that an insolvency law adopt an
approach that is not prescriptive and supports arrangements that will achieve
a result that provides more value to creditors than if the debtor were liquidated.

22. In discussing the core provisions of an effective and efficient insolvency
regime, the Legislative Guide focuses upon reorganization proceedings on the
one hand and liquidation proceedings on the other. However, the adoption of
this approach is not intended to indicate a preference for particular types of
proceeding or a preference for the manner in which the different proceedings
should be integrated into an insolvency law. Rather, the Guide seeks to com-
pare and contrast the core elements of the different types of proceeding and to
promote an approach that focuses upon maximizing the result for the parties
involved in an insolvency rather than upon strictly defined types of proceeding.
This may be achieved by designing an insolvency law that incorporates the
traditional formal elements in a way that promotes maximum flexibility.


                           1.    Reorganization proceedings
23. As a procedure designed to save a debtor or, failing that, a business,
reorganization may take one of several forms and may be more varied as to its
concept, acceptance and application around the world than liquidation. For the
sake of simplicity, the term “reorganization” is used in the Guide in a broad
sense to refer to the type of proceeding whose ultimate purpose is to allow the
debtor to overcome its financial difficulties and resume or continue normal
commercial operations (even though in some cases it may include a reduction
in the scope of the business, its sale as a going concern to another company
or its eventual liquidation).

24. Not all debtors that falter or experience serious financial difficulty in a
competitive marketplace should necessarily be liquidated; a debtor with a
reasonable prospect of survival (such as one that has a potentially profitable
business) should be given that opportunity where it can be demonstrated that
there is greater value (and, by deduction, greater benefit for creditors in the
long term) in keeping the essential business and other component parts of the
debtor together. Reorganization proceedings are designed to give a debtor
some breathing space to recover from its temporary liquidity difficulties or
more permanent overindebtedness and, where necessary, provide it with an
opportunity to restructure its debt and its relations with creditors. Where
reorganization is possible, generally it will be preferred by creditors if the
value derived from the continued operation of the debtor’s business will
enhance the value of their claims.

25. Reorganization, however, does not imply that all of the stakeholders must
be wholly protected or that they should be restored to the financial or commer-
cial position that would have obtained had the event of insolvency not oc-
curred. It does not imply that the debtor will be completely restored or its
creditors paid in full or that ownership and management of an insolvent debtor
will maintain and preserve their respective positions. Management may be
28                                       UNCITRAL Legislative Guide on Insolvency Law


terminated and changed, the interests of equity holders may be reduced to
nothing, employees may be retrenched and the source of a market for suppliers
may disappear. In general, however, reorganization does imply that whatever
form of plan, scheme or arrangement is agreed, the creditors will eventually
receive more than if the debtor were to be liquidated.

26. Additional factors supporting the use of reorganization include that the
modern economy has significantly reduced the degree to which the value of the
debtor’s assets can be maximized through liquidation. Where technical know-
how and goodwill are more important to the operation of a business than
physical assets, the preservation of human resources and business relations are
essential elements of value that cannot be realized through liquidation. Also,
long-term economic benefit is more likely to be achieved through reorganiza-
tion proceedings, since they encourage debtors to take action before their
financial difficulties become severe. Lastly, there are social and political con-
siderations that are served by the availability of reorganization proceedings,
which protect, for example, the employees of a troubled debtor.

27. Reorganization may take a number of different forms. It may include a
simple agreement concerning debts (referred to as a “composition”) where, for
example, the creditors agree to receive a certain percentage of the debts owed
to them in full, complete and final satisfaction of their claims against the
debtor. The debts are thus reduced and the debtor becomes solvent and can
continue to trade. It may also include a complex reorganization under which,
for example, debts are restructured (e.g. by extending the length of the loan
and the period in which payment may be made, deferring payment of interest
or changing the identity of the lenders); some debt may be converted to equity
together with a reduction (or even extinguishment) of existing equity; the non-
core assets may be sold; and unprofitable business activities closed. The choice
of the way in which reorganization is carried out is typically a response to the
size of the business and the degree of complexity of the debtor’s specific
situation.

28. Although reorganization may not be as widely included in insolvency
laws as liquidation and may not, therefore, follow such a common pattern,
there are a number of key or essential elements that can be determined:
     (a) Submission of the debtor to the proceedings (whether on its own
application or on the basis of an application by creditors), which may or may
not involve judicial control or supervision;
     (b) Automatic and mandatory stay or suspension of actions and proceed-
ings against the assets of the debtor affecting all creditors for a limited period
of time;
     (c) Continuation of the business of the debtor, either by existing man-
agement, an independent manager or a combination of both;
     (d) Formulation of a plan that proposes the manner in which creditors,
equity holders and the debtor itself will be treated;
     (e) Consideration of, and voting on, acceptance of the plan by creditors;
Part one:   II. Mechanisms for resolving a debtor’s financial difficulties     29


      (f)   Possibly, the judicial approval or confirmation of an accepted plan;
and
      (g) Implementation of the plan.

29. The benefits of reorganization are increasingly accepted and many insol-
vency laws include provisions on formal reorganization proceedings. The
extent to which formal reorganization proceedings, as opposed to some form
of voluntary negotiations, are relied upon to achieve the objectives of reorgani-
zation varies between countries. In any event, it is generally recognized that
the existence of liquidation under the insolvency law can facilitate the reorga-
nization of a debtor by providing an incentive to both creditors and debtors to
reach an appropriate agreement through a reorganization plan.

30. There is often, however, a correlation between the degree of financial
difficulty being experienced by the debtor, the complexity of its business
arrangements and the difficulty of the appropriate solution. Where, for example,
a single or small number of banks and institutional creditors are involved, it
is likely that the debtor can negotiate a voluntary restructuring agreement with
those creditors and resolve its difficulties without involving trade creditors and
without the need to commence proceedings under the insolvency law. Where
the financial situation is more complex and requires the involvement of a large
number of different types of creditor, a greater degree of formality may be
needed to find a solution that addresses the disparate interests and objectives
of those creditors, since voluntary restructuring agreements generally require
unanimity of the parties participating to be effective. In such situations, com-
mencement of reorganization proceedings under the insolvency law may assist
in achieving the desired goal where those proceedings enable a plan approved
by the requisite majority of creditors to be imposed upon a dissenting minority
of creditors. Thus, in some cases, proceedings under the insolvency law work
well precisely because they are regulated by that law, imposing the discipline
of the law on the participants, while at the same time providing certain protec-
tions. In other cases, voluntary negotiations succeed because they are not regu-
lated and avoid the delays and costs often associated with such regulation.

31. Since, as noted above, reaching agreement through voluntary restruc-
turing negotiations is often impeded by the ability of creditors to take indi-
vidual enforcement action and by the need for unanimous consent to alter the
terms of some existing classes of debt, some States have adopted different
types of mechanism, including “pre-insolvency” or “pre-packaged” pro-
cedures, to address those situations. The expedited reorganization proceedings
discussed in the Guide to address those situations follow the procedure of
reorganization, but on an expedited basis, combining voluntary restructuring
negotiations, where a plan is negotiated and agreed by the majority of affected
creditors, with reorganization proceedings commenced under the insolvency
law to obtain court confirmation of the plan in order to bind dissenting credi-
tors. Such proceedings are designed to minimize the cost and delay associated
with formal reorganization proceedings, while at the same time providing a
means by which a restructuring plan negotiated voluntarily by a debtor with
some or all of its creditors nevertheless can be approved in the absence of
30                                        UNCITRAL Legislative Guide on Insolvency Law


unanimous support of those creditors. They also allow the approval of the
restructuring plan obtained in the voluntary negotiations to be used to achieve
a reorganization that will bind creditors, at the same time providing the pro-
tections of the insolvency law to affected creditors. These types of procedure
are discussed in more detail in part two, chapter IV, paragraphs 76-94.

32. A different approach provides that, in order to facilitate the conclusion of
an amicable settlement with its creditors, a debtor may ask the court to appoint
a “conciliator”. The conciliator has no particular powers, but may request the
court to impose a stay of execution against all creditors if, in his or her
judgement, a stay would facilitate the conclusion of a settlement agreement.
During the stay, the debtor may not make any payments to discharge existing
debts (except salaries) or dispose of any assets other than in the ordinary
course of business. The procedure ends when agreement is reached either with
all creditors or (subject to court approval) with the main creditors; in the latter
case, the court may continue the stay against non-participating creditors by
providing a grace period to the debtor of up to two years.



                                2.   Liquidation
33. The type of proceeding referred to as “liquidation” is regulated by the
insolvency law and generally provides for a public authority (typically,
although not necessarily, a judicial court acting through a person appointed for
the purpose) to take charge of the debtor’s assets, with a view to terminating
the commercial activity of the debtor, transforming non-monetary assets into
monetary form and subsequently distributing the proceeds of sale or realization
of the assets proportionately to creditors. Although generally requiring the sale
or realization of assets to occur in a piecemeal manner as quickly as possible,
some insolvency laws permit liquidation to involve sale of the business in
productive units or as a going concern; under other laws that is only permis-
sible in reorganization. Liquidation usually results in the dissolution or disap-
pearance of a debtor that is a commercial legal entity and discharge of a natural
person debtor.

34. Around the world, liquidation proceedings tend to be very similar in their
concept, acceptance and application and normally follow a pattern that
includes:
     (a) An application to a court or other competent body either by the
debtor or by creditors;
     (b) An order or judgement that the debtor be liquidated;
     (c) Appointment of an independent person to conduct and administer the
liquidation;
     (d) Closure of the business activities of the debtor, if the business of the
debtor cannot be sold as a going concern, and termination of the powers of
owners and management and the employment of employees;
Part one:   II. Mechanisms for resolving a debtor’s financial difficulties       31


     (e) Sale or realization of the debtor’s assets, either piecemeal or as a
going concern;
     (f) Adjudication of the claims of creditors;
     (g) Distribution of available funds to creditors (under some form of
priority); and
     (h) Dissolution of the debtor, where it is a corporation or some other
form of legal person, or discharge, in the case of a natural person.

35. There are a number of legal and economic justifications for liquidation.
Broadly speaking, it can be argued that a commercial business that is unable
to compete in a market economy should be removed from the marketplace. A
principal identifying mark of an uncompetitive business is one that satisfies
one of the tests of insolvency, that is, it is unable to meet its mature debts as
they become due or its debts exceed its assets. More specifically, the need for
liquidation proceedings can be viewed as addressing inter-creditor problems
(when an insolvent debtor’s assets are insufficient to meet the claims of all
creditors it will be in a creditor’s own best interests to take action to recover
its claim before other creditors can take similar action) and as a disciplinary
force that is an essential element of a sustainable debtor-creditor relationship.
Orderly and effective liquidation proceedings address the inter-creditor
problem by setting in motion a collective proceeding that seeks to avoid those
actions which, while viewed by individual creditors as being in their own best
self interest, essentially lead to the loss of value for all creditors. A collective
proceeding is designed to provide equitable treatment to creditors, by treating
similarly situated creditors in the same way, and to maximize the value of the
debtor’s assets for the benefit of all creditors. This is normally achieved by the
imposition of a stay on the ability of creditors to enforce their individual rights
against the debtor and the appointment of an independent person whose
primary duty is to maximize the value of the debtor’s assets for distribution to
creditors.

36. An orderly and relatively predictable mechanism for the enforcement of
the collective rights of creditors can also provide creditors with an element of
predictability at the time they make their lending decisions and can more
generally promote the interest of all participants in the economy by facilitating
the provision of credit and the development of financial markets. This is not
to say that an insolvency law should function as a means of enforcing the
rights of individual creditors, although there is a clear and important relation-
ship between enforcement and insolvency mechanisms. The efficiency and
effectiveness of procedures for the individual enforcement of creditors’ rights
will mean that creditors are not forced to use insolvency proceedings for that
purpose, especially since insolvency proceedings generally require a level of
proof, cost and procedural complexity that makes it unsuitable for use in that
way. Nevertheless, effective insolvency proceedings will ensure that where
debt enforcement mechanisms fail, creditors will have an avenue of final re-
course that can operate as an effective incentive to a recalcitrant debtor to pay
a particular creditor.
32                                       UNCITRAL Legislative Guide on Insolvency Law


                      D.    Administrative processes
37. In recent years a number of crisis-affected jurisdictions have developed
semi-official “structured” forms of insolvency processes, inspired largely by
government or central banks, to deal with systemic financial problems within
the banking sector. These processes have been developed on a similar pattern.
Firstly, each has a facilitating agency to encourage and, in part, coordinate and
administer the process to provide the incentive and motivation necessary for its
development. Secondly, each process is underpinned by an agreement between
commercial banks in which the participants agree to follow a set of “rules” in
respect of corporate debtors that are indebted to one or more of the banks and
may participate in the process. The rules provide the procedures to be followed
and the conditions to be imposed in cases where corporate reorganization is
attempted. In some of the jurisdictions, a debtor corporation that seeks to
negotiate reorganization under this process is required to agree to the applica-
tion of these rules. Thirdly, time limits are provided for various parts of the
process and, in some cases, agreements in principle can be referred to
the relevant court for reorganization proceedings to commence under the
insolvency law. In addition, one jurisdiction established a special agency that
has extremely wide powers under its governing legislation to acquire non-
performing loans from the banking and finance sector and then to impose
extrajudicial processes upon a defaulting corporate debtor, including a forced
or imposed reorganization.

38. Both because these processes are relatively complex and involve the
development of special rules and regulations and because they address particu-
lar situations of systemic failure, they are not discussed in the Legislative
Guide.
                        III. Institutional framework
1. An insolvency law is a part of an overall commercial legal system and is
heavily reliant for its proper application not only on a well-developed commer-
cial legal system, but also on a well-developed institutional framework for
administration of the law. The choices made in developing or reforming an
insolvency law will therefore need to be closely linked to the capacities of
existing institutions. The insolvency system will only be effective if the courts
and officials responsible for its implementation have the necessary capacity to
provide the most efficient, timely and fair outcome to those for whose benefit
an insolvency regime exists. If that institutional capacity does not already exist,
it is highly desirable that reform of the insolvency law be accompanied by
institutional reform, where the costs of establishing and maintaining the neces-
sary institutional framework are weighed against the benefits of providing a
system that is efficient and effective and in which the public has confidence.
Although a detailed discussion of the means by which such institutional capa-
city can be developed or enhanced is beyond the scope of the Legislative
Guide, a number of general observations can be made.1

2. In most jurisdictions, insolvency proceedings are administered by a judi-
cial authority, often through commercial courts or courts of general jurisdiction
or, in a few cases, through specialized bankruptcy courts. Sometimes judges
have specialized knowledge and responsibility only for insolvency matters,
while in other cases insolvency matters are just one of a number of wider
judicial responsibilities. In a few jurisdictions, non-judicial or quasi-judicial
institutions fulfil the role that, in other jurisdictions, is played by the courts.

3. In designing the insolvency law it may be appropriate to consider the
extent to which courts will be required to supervise the proceedings and
whether or not their role can be limited with respect to different parts of the
proceedings or balanced by the role of other participants, such as the creditors

       1
         A number of international organizations are undertaking work on institutional capacity-
building. It is beyond the scope of the Legislative Guide to provide an exhaustive survey of the
institutions involved, but some example are: INSOL International, which is involved in providing
training and technical assistance for insolvency practitioners, judges, regulators and lenders through
conferences, ad hoc training and technical research; the Asian Development Bank, which provides
assistance to Governments to enhance the performance of public institutions, especially courts, regu-
latory institutions and ministries of justice, through the establishment of legal training institutions,
web-based access to training and legal research materials; the World Bank, which recognizes the
importance of strong institutions to sustainable development, supports client countries in their efforts
to strengthen institutional capacity through a wide range of lending, assessment, technical assistance
and knowledge products; and the International Monetary Fund, which provides expert training, work-
shops and seminars for the authorities of member countries to help strengthen their legal infrastructure
and institutional performance of the judiciary, where such issues are macroeconomically relevant.
More information can be obtained from the institutions in question.


                                                  33
34                                       UNCITRAL Legislative Guide on Insolvency Law


and the insolvency representative. This is of particular importance where the
insolvency law requires judges to deal quickly with difficult insolvency issues
(which often involve commercial and business questions) and the capacity of
the judiciary is limited, whether because of its size, a general lack of resources
in the court system or a lack of specific knowledge and experience of the types
of issue likely to be encountered in insolvency.

4. To reduce the functions to be performed by the court under an insolvency
law, but at the same time provide the necessary checks and balances, an
insolvency law can assign specific functions to other participants, such as
the insolvency representative and creditors, or to some other authority, such as
an insolvency or corporate regulator. An insolvency law may provide that the
insolvency representative, for example, is authorized to make decisions on a
number of issues, such as verification and admission of claims, the need for
post-commencement funding, surrender of encumbered assets of no value to
the estate, sale of major assets, commencement of avoidance actions and
treatment of contracts, without the court being required to intervene, except in
the case of a dispute concerning one of these matters. The use of this approach
depends upon the availability of a body of suitably qualified professionals
to serve as insolvency representatives. Creditors also can be authorized to
provide advice to, or to approve certain decisions of, the insolvency repre-
sentative, such as approving the sale of important assets or obtaining post-
commencement finance, without requiring the court to intervene, except in the
case of dispute. An insolvency law can specify the decisions that will require
court approval, such as the provision of a priority ranking above the rights of
existing secured creditors to secure post-commencement finance.

5. The court’s capacity to handle the sometimes complex commercial issues
involved in insolvency cases is often not only a question of knowledge and
experience of specific law and business practices, but also a question of that
knowledge and experience being current and regularly updated. To address the
issue of judicial capacity, a special focus on the education and ongoing training
of court personnel, not only of judges but also of clerks and other court admi-
nistrators, will assist in supporting an insolvency regime that has the ability to
respond effectively and efficiently to its insolvency caseload.

6. A further consideration related to the court’s capacity to supervise insol-
vency cases is the balance in the insolvency law between mandatory and
discretionary components. While mandatory elements, such as automatic com-
mencement or automatic application of the stay, may provide a high degree of
certainty and predictability for debtor and creditors, as well as limiting the
matters requiring consideration by the courts, it may also lead to rigidity if
there are too many of these types of element. A discretionary approach allows
the court to weigh facts and circumstances, taking into account precedent,
community interests and the interests of persons affected by the decision and
market conditions. Nevertheless, that approach may also impose a burden on
the court where it does not have the knowledge or experience required to
weigh these considerations or the resources to respond in a timely manner.
Where the insolvency law provides for confirmation of a reorganization plan
Part one: III. Institutional framework                                         35


by the court, for example, it is not desirable to ask the court to undertake
complex economic assessments of the feasibility or desirability of the plan, but
rather to limit its consideration to the conduct of the approval process and other
specified issues and rely upon creditors having sufficient commercial acumen
to make an informed decision on approval of the plan. Where an insolvency
law requires the exercise of discretion by a decision maker, such as a court, it
is preferable that adequate guidance as to the proper exercise of that discretion
also be included, in particular where economic or commercial issues are
involved. This approach is consistent with a general objective of ensuring the
transparency and predictability of insolvency proceedings.

7. The adequacy of the legal infrastructure and, in particular, the resources
available to courts dealing with insolvency cases, may be a significant influ-
ence on the efficiency with which insolvency cases are handled and the length
of time required for insolvency proceedings. This may be a relevant considera-
tion in deciding whether the insolvency law should impose time limits for the
conduct of certain parts of the proceedings. If the court infrastructure is not
able to respond to the demands placed upon it in a timely manner to ensure that
time limits are observed by the parties and the insolvency proceedings proceed
quickly, the inclusion of such provisions in the law will not achieve the goal
of establishing an effective and efficient insolvency regime. Procedural rules
will also be of importance to the conduct of cases and well-developed rules
will assist courts and the professionals handling insolvency cases to provide an
effective and orderly response to the economic situation of the debtor, mini-
mizing the delays that can result in diminution in value of the debtor’s assets
and impair the prospects of successful insolvency proceedings (whether liqui-
dation or reorganization). Such rules will also assist in achieving a degree of
predictability and uniformity of treatment from one case to the next.

8. Implementing an insolvency system depends not only on the court, but
also on the professionals involved in insolvency proceedings, whether they are
insolvency representatives, legal advisers, accountants, valuation specialists or
other professional advisers. The adoption of professional standards and train-
ing may assist in developing capacity. It may be appropriate to assess which
insolvency functions are truly public in nature and therefore should be per-
formed in the public sector in order to ensure the level of trust and confidence
required to make the insolvency system effective and those functions which
can be performed by the creation of adequate incentives for private-sector
participants in insolvency proceedings, such as the function of insolvency
representative.
                               Part two
       Core provisions for an effective
        and efficient insolvency law
1. Part two of the Legislative Guide focuses on the content of the insolvency
law and the core elements that are regarded as necessary for insolvency pro-
ceedings conducted under the law to be effective and efficient. As far as
possible, the order in which the Guide addresses the core elements corresponds
to the sequence of insolvency proceedings.

2. Chapter I analyses application and commencement criteria. Chapter II
considers the effects of commencement of insolvency proceedings on the
debtor and its assets, including constitution of an insolvency estate, protection
and preservation of the estate, use and disposal of assets, post-commencement
finance, treatment of contracts, exercise of avoidance provisions, rights of set-
off and financial contracts and netting. Chapter III examines the role of the
debtor and the insolvency representative in insolvency proceedings and their
various duties and functions, as well as mechanisms to facilitate creditor
participation. While issues relevant to reorganization are considered through-
out the Guide, chapter IV examines, in particular, issues relating to the
proposal and approval of a reorganization plan and expedited reorganization
proceedings. Chapter V addresses different types of creditor claim and their
treatment, as well as establishment of priorities for distribution. Chapter VI
deals with issues relating to the conclusion of insolvency proceedings, includ-
ing discharge and closure. Cross-border insolvency issues are addressed in the
UNCITRAL Model Law on Cross-Border Insolvency and its Guide to
Enactment (see annex III).




                                       37
38                                                  UNCITRAL Legislative Guide on Insolvency Law


                 I. Application and commencement
                           A.     Eligibility and jurisdiction
       1.     Eligibility: debtors to be covered by an insolvency law
1. An important threshold issue in designing an insolvency law focused on
debtors engaged in economic activities1 (whether or not they are conducted for
profit) is determining and clearly defining which debtors will be subject to the
law. To the extent that any debtor is excluded from the law, it will not enjoy
the protections offered by the law, nor will it be subject to the discipline of the
law. This argues in favour of an all-inclusive approach to the design of an
insolvency law, with limited exceptions. The design of eligibility provisions
for an insolvency law raises two basic questions. Firstly, whether the law
should distinguish between debtors who are natural persons and debtors that
are some form of limited liability enterprise or corporation or other legal
person, each of which will raise not only different policy considerations, but
also considerations concerning social and other attitudes. Secondly, the types
of debtor, if any, that should be excluded from the application of the law.

2. States adopt different approaches to defining the scope of application of
their insolvency laws. Some insolvency laws apply to all debtors with certain
specified exceptions, such as those discussed below. Other States distinguish
between natural person debtors and juridical or legal person debtors and pro-
vide different insolvency laws for each. A further approach distinguishes
between legal and natural persons on the basis of their engagement in
economic (or consumer) activities. Some of these laws address the insolvency
of “merchants”, which are defined by reference to engagement in economic
activities as an ordinary occupation, or companies incorporated in accordance
with commercial laws and other entities that regularly undertake economic
activities. Some laws also include different procedures based on levels of
indebtedness and a number of States have developed special insolvency
regimes for different sectors of the economy, in particular the agricultural
sector.

(a)   Natural persons engaged in economic activities
3. Policies applicable to individual or personal debt and insolvency often
evidence cultural attitudes that are not as relevant to debtors engaged in eco-
nomic activity. These may include, for example, attitudes toward the incurring
of personal debt; the availability of relief for unmanageable debt; the social

       1
         The term “economic activities” should be given a broad interpretation so as to cover matters
arising from all relationships involving economic activity, whether contractual or not. These relation-
ships would include, but are not limited to, the following transactions: any trade transaction for the
supply or exchange of goods or services; distribution agreement; commercial representation or agency;
factoring; leasing; construction of works; consulting; engineering; licensing; investment; financing;
banking; insurance; exploitation agreement or concession; joint venture and other forms of industrial
or business cooperation; and carriage of goods or passengers by air, sea, rail or road.
Part two: I. Application and commencement                                       39


effect of bankruptcy on the status of individuals; the need for counselling and
educational assistance with respect to individual debt; and the provision of a
fresh start for debtors through a discharge (release of the debtor from liability
for part or all of certain debts after the closure of the proceedings—see
chap. VI, paras. 1-13). Policies applicable to insolvency in the commercial
sector, in comparison, are generally restricted to economic and commercial
considerations such as the important role that business plays in the economy;
the need to preserve and encourage economic and entrepreneurial activity; and
the need to encourage the provision of credit and protect creditors.

4. The interests of natural persons involved in economic activity (including,
for example, partnerships of individuals and sole traders) differ from those of
consumer debtors, at least in some aspects of their indebtedness, but it is often
difficult to separate an individual’s personal indebtedness from their business
indebtedness for the purposes of determining how they should be treated in
insolvency. Different tests may be developed to facilitate that determination,
by focusing, for example, upon the nature of the activity being undertaken, the
level of debt and the connection between the debt and the economic activity.
Indicators of involvement in economic activity may include whether the busi-
ness is registered as a trading or other business operation; whether it is a
certain type of legal person under the commercial law; the nature of its regular
activities; and information concerning turnover and assets and liabilities.

5. Many States include natural person debtors involved in economic activity
within the scope of their commercial insolvency laws. The experience of other
States suggests that although business activities conducted by natural persons
form part of economic activity, those cases often are best dealt with under the
regime for insolvency of natural persons because ultimately the proprietor of
a personal business will conduct his or her activities through a structure that
does not enjoy any limits on liability, leaving them personally liable, without
limitation, for the debts of the business. These cases also raise difficult issues
of discharge, including the length of time required to expire before the debtor
can be discharged and the obligations that can be discharged or exempted from
discharge. Debts that cannot be discharged often involve personal matters such
as settlements in divorce proceedings or child support obligations.

6. An additional consideration is that the inclusion of natural persons in the
commercial insolvency regime may have the potential, in some States, to act
as a disincentive to use of the commercial regime because of the social attitude
towards personal insolvency, irrespective of its nature. It is desirable that these
concerns be considered in designing a law to address business-related insol-
vency, taking into account the manner in which economic activity is generally
conducted in a particular State and the existence and effectiveness of insol-
vency laws dealing with natural persons. In many States, for example, eco-
nomic activity is conducted almost exclusively by individuals and to exclude
them from the insolvency law would significantly limit its operation and effec-
tiveness. In others, insolvency of natural persons engaged in economic activity
is specifically addressed by the personal insolvency law and they are excluded
from the commercial insolvency regime.
40                                                   UNCITRAL Legislative Guide on Insolvency Law


7. The Legislative Guide focuses upon the conduct of economic activities by
both legal and natural persons, irrespective of the legal structure through which
those activities are conducted and whether or not they are conducted for
profit.2 It identifies those issues where additional or different provisions will be
required if natural person debtors are included in the insolvency law.

(b)   State-owned enterprises
8. An insolvency law can apply to all types of debtor engaged in economic
activities, both private and state-owned, especially those state-owned enter-
prises which compete in the market place as distinct economic or business
operations and otherwise have the same commercial and economic interests as
privately-owned businesses. The discussion here is not intended to include
States, subnational governments, municipalities and other similar types of
organization or public authority, unless they are state-owned enterprises
operating as commercial enterprises.

9. Government ownership of an enterprise may not, in and of itself, provide
a sufficient basis for excluding the enterprise from the coverage of the insol-
vency law, although a number of States do adopt that approach. Where the
State plays different roles with respect to the enterprise not only as owner, but
also as lender and largest creditor, normal commercial incentives will not
apply, compromise solutions may be difficult to achieve and there is clear
ground for conflicts of interest to arise. Inclusion of these enterprises in the
insolvency regime therefore has the advantages of subjecting them to the dis-
cipline of the regime, sending a clear signal that government financial support
for such enterprises will not be unlimited and providing a procedure that has
the potential to minimize conflicts of interest.

10. The need for exceptions to a general policy of inclusion of such enter-
prises in a general insolvency law may arise where the Government has
adopted a policy of extending an explicit guarantee in respect of the liabilities
of such enterprises, where the treatment of state enterprises is part of a change
in macroeconomic policy, such as a large-scale privatization programme or
where state-owned enterprises are involved in sensitive sectors of the
economy, such as provision of key services or utilities (e.g. electricity and
water). In these cases, independent legislation dealing with relevant issues,
including insolvency, may be warranted. The Guide does not address issues
specifically relevant to that independent legislation.

(c)   Debtors requiring special treatment
11. Although it may be desirable to extend the protections and discipline of
an insolvency law to as wide a range of debtors as possible, separate treatment
may be provided for certain entities of a specialized nature, such as banking
and insurance institutions, utility companies and stock or commodity brokers.


      2
          It would include, for example, economic activity conducted for charitable purposes.
Part two: I. Application and commencement                                        41


Exceptions for these types of debtor are widely reflected in insolvency laws
and are generally justified on the basis of the detailed regulatory legal regimes
to which these businesses are often subjected outside the insolvency context.
To address the insolvency of such debtors, regulatory regimes can include
provisions particular to the type of business being regulated or special rules
can be included in the general insolvency law. The special considerations
arising from the insolvency of such debtors and consumer insolvency are not
specifically addressed in the Legislative Guide.


                                  2.   Jurisdiction
12. In addition to possessing the necessary business or economic attributes, a
debtor must have a sufficient connection to the State to be subject to its
insolvency laws. In many cases, no issue as to the applicability of the insol-
vency law will arise as the debtor will be a national or resident of the State and
will conduct its economic activities in the State through a legal structure
registered or incorporated in the State. However, where there is a question of
the debtor’s connection with the State, insolvency laws adopt different tests,
including whether the debtor has its centre of main interests in the State,
whether the debtor has an establishment in the State or whether it has assets
in the State.

(a)   Centre of main interests
13. Although some insolvency laws use tests such as principal place of busi-
ness, UNCITRAL has adopted, in the Model Law on Cross-Border Insolvency,
the test of “centre of main interests” of the debtor to determine the proper
location for commencement of what is termed the “main proceedings” for that
debtor. That test is also used in European Council (EC) Regulation No. 1346/
2000 of 29 May 2000 on insolvency proceedings. The UNCITRAL Model Law
does not define the term; the EC Regulation (recital 13) indicates that the term
should correspond to “the place where the debtor conducts the administration
of his interests on a regular basis and is therefore ascertainable by third
parties”. An appropriate test would be the one provided in article 16, para-
graph 3, of the UNCITRAL Model Law and article 3 of the EC Regulation: the
debtor’s registered office, or habitual residence in the case of an individual, is
presumed to be the centre of main interests, unless it can be shown that the
centre of main interests is elsewhere. A debtor that has the centre of its main
interests in a State should be subject to that State’s insolvency law.

14. Notwithstanding the adoption of the “centre of main interests” test, a
debtor that has assets in more than one State may find itself satisfying the
requirements to be subject to the insolvency law of more than one State
because of the different tests of debtor eligibility or different interpretations of
the same test, with the resultant possibility of separate insolvency proceedings
in those States. In such cases, it will be appropriate to have in place legislation
based on the UNCITRAL Model Law to address questions of coordination and
cooperation. In terms of the application of different tests, the Model Law
42                                                UNCITRAL Legislative Guide on Insolvency Law


focuses on the primacy of centre of main interests and main proceedings, but
recognizes that other tests, such as presence of assets, can be used to com-
mence local “non-main” proceedings to deal with local assets once the foreign
main proceedings have been recognized.3


(b)   Establishment
15. Some laws provide that insolvency proceedings may be commenced in a
jurisdiction where the debtor has an establishment. The term “establishment”
is defined in article 2 of the UNCITRAL Model Law as “any place of opera-
tions where the debtor carries out a non-transitory economic activity with
human means and goods or services”. Article 2 of the EC Regulation includes
a similar definition, but omits the reference to “services”. Essentially, an estab-
lishment is a place of business, which is not necessarily the centre of main
interests. The definition, like the term “centre of main interests”, is important
to the overall structure of the UNCITRAL Model Law and its treatment of
cross-border insolvency cases as a criterion for recognition of foreign insol-
vency proceedings and the application of measures for relief. In many
countries, managers of an establishment that is unable to pay its debts will have
personal liability to creditors unless they commence insolvency proceedings.
Eligibility to commence proceedings on the basis of an establishment is there-
fore of relevance to a domestic insolvency regime and the treatment of that
debtor’s assets in a particular State.

16. The EC Regulation similarly provides that insolvency proceedings may be
opened in a jurisdiction where a debtor has an establishment (termed “second-
ary proceedings”). Generally those proceedings will be restricted to liquidation
proceedings covering the assets of the debtor situated in the territory of that
State. Depending upon the nature of the debtor’s business and the assets con-
cerned, there may be limited situations where reorganization proceedings could
be based upon establishment.


(c)   Presence of assets
17. Some laws provide that insolvency proceedings may be commenced by or
against a debtor that has or has had assets within a jurisdiction without requir-
ing the debtor to have an establishment or centre of main interests in the
jurisdiction. The UNCITRAL Model Law does not provide for the recognition
of foreign proceedings commenced on the basis of presence of assets, although
it does provide for local proceedings based on presence of assets to be com-
menced in a State recognizing foreign main proceedings in order to deal with
those local assets.4



      3
          UNCITRAL Model Law, article 28 (see annex III).
      4
          UNCITRAL Model Law, article 28, and Guide to Enactment, paras. 184-187 (see annex III).
Part two: I. Application and commencement                                              43


18. A distinction can perhaps be made between liquidation and reorganization
proceedings commenced on the basis of presence of assets; while presence of
assets may be an appropriate basis for commencement of liquidation proceed-
ings involving specific assets located in a State, it may not be sufficient for the
commencement of reorganization proceedings, in particular where proceedings
commenced in the centre of main interests are liquidation proceedings or
where the assets in question are limited. Although one State does provide that
the presence of assets will be sufficient to commence reorganization proceed-
ings (and that those proceedings can involve the assets of the debtor wherever
located), this option is not widely available. Where proceedings are com-
menced against a multinational debtor on the basis of presence of assets, there
generally will be a need to coordinate those proceedings with other jurisdic-
tions where the debtor will have its centre of main interests and possibly
establishments. The test of presence of assets may therefore raise multi-
jurisdictional issues, including the possibility of multiple proceedings and
questions of coordination and cooperation between proceedings that are
addressed by the UNCITRAL Model Law.

(d)    Competent courts
19. An additional issue of jurisdiction is the question of which court is com-
petent to commence insolvency proceedings and to resolve matters arising in
the course of those proceedings. The competence for commencement and all
later issues arising in the conduct of insolvency proceedings may lie with the
same court of a State or different courts will have competence for different
issues. To increase the transparency and ease of use of the insolvency law for
the benefit of debtors, creditors and third parties (especially where they are
from a foreign country), it should be made clear in the law which courts have
jurisdiction for which functions. Although provisions specifying which courts
have jurisdiction over insolvency proceedings may not always be included in
the insolvency law, a reference to the provisions of the law other than the
insolvency law that specifies court jurisdiction might usefully be included in
the insolvency law.



                               Recommendations 8-13

      Purpose of legislative provisions

          The purpose of provisions on eligibility and jurisdiction is to establish:
          (a) The types of debtor that are subject to the insolvency law;
          (b) The types of debtor that may be excluded from the insolvency law;
           (c) The debtors that have sufficient connection to a State to be subject
      to the insolvency law; and
          (d) The courts that have jurisdiction over the commencement and con-
      duct of insolvency proceedings.
44                                                  UNCITRAL Legislative Guide on Insolvency Law




     Recommendations 8-13 (continued)
     Contents of legislative provisions
     Eligibility (paras. 1-11)
          8. The insolvency law should govern insolvency proceedings against all
     debtors that engage in economic activities, whether natural or legal persons,
     including state-owned enterprises,5 and whether or not those economic activi-
     ties are conducted for profit.

          9. Exclusions from the application of the insolvency law should be
     limited and clearly identified in the insolvency law.6

     Jurisdiction ( paras. 12-18)
          10. The insolvency law should specify which debtors have sufficient
     connection to the State to be subject to its insolvency law. Different
     approaches may be taken to identifying appropriate connecting factors, but the
     grounds upon which a debtor can be subject to the insolvency law should
     include:7
           (a) That the debtor has its centre of main interests in the State; or
           (b) That the debtor has an establishment in the State.

          11. The insolvency law should establish a presumption that, in the
     absence of proof to the contrary, a legal person’s centre of main interests is in
     the State in which it has its registered office, and a natural person’s centre of
     main interests is in the State in which that person has their habitual residence.

          12. The insolvency law should define “establishment” to mean “any
     place of operations where the debtor carries out a non-transitory economic
     activity with human means and goods or services”.8

     Competent courts (para. 19)
          13. The insolvency law should clearly indicate (or include a reference to
     the relevant law that establishes) the court that has jurisdiction over the com-
     mencement and conduct of insolvency proceedings, including matters arising
     in the course of those proceedings.


       5
         It is not intended that the Guide should apply to the insolvency of States, subnational
governments, municipalities and other similar types of organization, except to the extent that they are
a “state-owned enterprise”.
       6
         Highly regulated organizations such as banks and insurance companies may require specialized
treatment that can appropriately be provided in a separate insolvency regime or through special
provisions in the general insolvency law. Some state-owned enterprises, such as those involved in
sensitive sectors of the economy, might also be excluded.
       7
         This recommendation is intended to indicate minimum and non-exclusive grounds for
commencing insolvency proceedings. Other grounds, such as presence of assets, are used in some
jurisdictions, but are not recommended: see above, paras. 17 and 18, and the Guide to Enactment of
the UNCITRAL Model Law (see annex III), paras. 184-187.
       8
         UNCITRAL Model Law, art. 2, para. (f), (see annex III).
Part two: I. Application and commencement                                                          45


                       B.     Commencement of proceedings
                                       1.    Introduction
20. The standard to be met for commencement of insolvency proceedings is
central to the design of an insolvency law. As the basis upon which insolvency
proceedings can be commenced, this standard is instrumental to identifying the
debtors that can be brought within the protective and disciplinary mechanisms
of the insolvency law and determining who may make an application for
commencement, whether the debtor, creditors or other parties.

21. As a general principle it is desirable that the commencement standard be
transparent and certain, facilitating access to insolvency proceedings conven-
iently, cost-effectively and quickly to encourage financially distressed or insol-
vent businesses to voluntarily commence proceedings. It is also desirable that
access be flexible in terms of the types of insolvency proceedings available
(reorganization and liquidation), and the ease with which the proceedings most
relevant to a particular debtor can be accessed, and that conversion between
the different types of proceeding can be achieved. Restrictive access can deter
both debtors and creditors from commencing proceedings, while the effects of
delay can be harmful to the value of assets and the successful completion of
insolvency proceedings, in particular in cases of reorganization. Ease of access
needs to be balanced with proper and adequate safeguards to prevent improper
use of proceedings. Examples of improper use may include application by a
debtor that is not in financial difficulty in order to take advantage of the
protections provided by the insolvency law, such as the automatic stay, or to
avoid or delay payment to creditors and application by creditors who are
competitors of the debtor, where the purpose of the application is to take
advantage of insolvency proceedings to disrupt the debtor’s business and thus
gain a competitive edge.9

22. Laws differ on the specific standard that must be satisfied before
insolvency proceedings can commence. A number of laws include alternative
standards and distinguish between the standard applicable to commencement
of liquidation and reorganization proceedings, as well as between applications
by a debtor and a creditor or creditors.

                             2.    Commencement standards
(a)    Liquidity, cash flow or general cessation of payments test
23. A standard that is used extensively for commencement of insolvency
proceedings is what is variously known as the liquidity, cash flow or general
cessation of payments tests. This requires that the debtor has generally ceased
making payments and will not have sufficient cash flow to service its existing


       9
         This is discussed further in the context of denial of the application to commence and discon-
tinuation of proceedings, see below paras. 61-63 and 79.
46                                                 UNCITRAL Legislative Guide on Insolvency Law


obligations as they fall due in the ordinary course of business. Indicators of a
debtor’s general cessation of payments may include its failure to pay rent,
taxes, salaries, employee benefits, trade accounts payable and other essential
business costs. As such, this test puts the defining factors within the reach of
creditors. Reliance on this test is designed to activate insolvency proceedings
sufficiently early in the period of the debtor’s financial distress to minimize
dissipation of assets and avoid a race by creditors to grab assets that would
cause dismemberment of the debtor to the collective disadvantage of all credi-
tors. Allowing commencement of proceedings to take place only when the
debtor can demonstrate balance sheet insolvency (when the debtor’s balance
sheet shows that the value of its liabilities exceed its assets—as discussed
below), may serve only to delay the inevitable and diminish recoveries.

24. One issue associated with the general cessation of payments test that
needs to be considered is that the inability of the debtor to pay its debts as they
become due may point only to a temporary cash flow or liquidity problem in
a business that is otherwise viable. In today’s competitive markets, competition
may compel market participants to accept ever-lower profits or even losses on
a temporary basis in order to become competitive and maintain or gain market
share. While it will be a question of fact in each case, it is desirable that an
insolvency law provide guidance for the court to determine whether or not the
commencement standard has been met in order to avoid a premature finding
of insolvency.

(b)   Balance sheet test
25. An alternative standard to general cessation of payments is the balance
sheet test, which is based on excess of liabilities over assets as an indication
of financial distress. Since it relies on information under the control of the
debtor, a practical limitation of the balance sheet test is that it is rarely possible
for other parties to ascertain the true state of the debtor’s financial affairs until
after its difficulties have become a settled and often irreversible fact and thus
it may not easily form the basis for a creditor application. In addition, it may
give a misleading indication of the debtor’s financial situation because it
focuses upon what is essentially an accounting question of how assets should
be valued (e.g. a liquidation value as opposed to a going concern value). It also
raises questions of whether a debtor’s balance sheet is reliable and gives a
true indication of the debtor’s ability to pay, in particular where accounting
standards and valuation techniques give rise to results that do not reflect the
fair market value10 of a debtor’s assets or where markets are not sufficiently
developed or stable to enable that value to be established. This may be

       10
          Fair market value is generally considered to be the value that reasonably can be expected to
be obtained in an “arm’s-length” sale between a buyer and a seller, where neither party is under a
compulsion to buy or sell. In the absence of a real sale, value may be somewhat speculative, as it is
based on assumptions made about the conditions for the sale of the assets in question. To reduce the
speculation, techniques have been developed to approximate value on the basis of sale of comparable
businesses and assets or on the basis of a multiple of the enterprise’s earnings potential. In markets
where assets cannot easily be sold, either because the market is saturated or because a market for the
assets in question does not exist, value is difficult to measure.
Part two: I. Application and commencement                                                            47


particularly true in the case of service businesses that under this test may
technically be insolvent because of a lack of assets, even when the business is
essentially viable. Alternatively, a business may have a positive balance sheet
without the cash flow necessary to sustain its operations.

26. This test can also lead to delay and difficulties of proof as an expert would
generally be required to review books, records and financial data11 to reach a
determination of the fair market value of the business. This will be especially
difficult where those records are not properly maintained or readily available.
For these reasons, the balance sheet test often leads to proceedings being
commenced after the possibilities of reorganization have disappeared and can
have a negative effect on the debtor’s ability to deal collectively with its
creditors when it maintains an operating business, thus circumventing the
objective of maximization of value. It will thus not be sufficiently reliable to
constitute the sole basis of a definition of insolvency and it may be desirable
to use it in conjunction with the cessation of payments test. When used in that
manner, the balance sheet test can assist in defining insolvency by focusing on
whether the assets, however valued, will be sufficient to satisfy the debtor’s
liabilities, including those obligations which are not yet mature.

(c)   Designing the commencement standard
27. Insolvency laws use the general cessation of payments test and the
balance sheet test in different combinations to establish a commencement
standard. Some laws adopt a simple form of the general cessation of payments
test, requiring that the debtor be unable to meet its obligations as they fall due.
Other laws adopt that test but add further requirements, for example, that the
cessation of payments must reflect a difficult financial situation that is not
temporary, that the creditworthiness of the debtor must be at stake and that it
be just and equitable for the debtor to be liquidated. The more elements are
added to the commencement standard, the more difficult it will be to satisfy,
especially where the elements included are subjective. This may lead to appli-
cations for commencement of insolvency proceedings being contested, causing
delay, uncertainty and expense. By contrast, tests that are relatively simple and
straightforward may have a tendency to include more cases, but this may be
balanced by the increased ease of application that results from such tests.

28. Another approach combines the cessation of payments test with the
balance sheet test. One example requires that, in addition to having ceased


       11
         The book value of an asset is the amount for which the asset is shown for accounting purposes.
It is usually derived from the original acquisition value, which is adjusted for a combination of
depreciation, amortization and revaluation to any lower current market price or, occasionally, revalua-
tion upwards in accordance with accounting principles. Although international financial reporting
standards have been produced by the International Accounting Standards Board, it is important to note
that there are no universally agreed accounting guidelines that dictate the basis on which assets should
be valued for accounting purposes. Furthermore, the book value of assets for management account
purposes may not be the same as the values for which the same assets are included in year-end audited
financial statements. The result is that the book values of assets may bear little or no relationship to
the amounts for which they could be realized to satisfy creditors.
48                                         UNCITRAL Legislative Guide on Insolvency Law


making payments, the debtor must be overindebted, where overindebtedness is
determined, for example, by the debtor’s inability to satisfy its debts as they
become mature because its liabilities exceed its assets. An approach that
combines the two tests may support commencement where there is a lack of
information as to the existence of a general default and provide a more
complete picture of the debtor’s present and prospective financial situation.
The balance sheet test may facilitate, for example, consideration of immature
debt that would not otherwise be considered under the cessation of payments
test, but which will be very relevant, for example, to the likely success of
reorganization.

29. An insolvency law may adopt a single standard for insolvency, in which
case the cessation of payments test provides an efficient trigger for access to
insolvency proceedings; the balance sheet test, as noted above, suffers from a
number of disadvantages and should not be used as the single test. An
insolvency law may also adopt a standard that contains both the cessation of
payments test and the balance sheet test. Where this approach is followed,
proceedings can be commenced if either of the tests can be satisfied.


     (i)   Imminent insolvency (prospective illiquidity)
30. Some laws that adopt only a cessation of payments test also make pro-
vision for a debtor to apply for commencement on the basis of imminent
insolvency or prospective inability to pay, where the debtor will be unable to
meet its future obligations as they fall due. While in some cases the prospective
inability might relate to a short period of time into the future, there may be
cases where it will relate to a significantly longer term, depending upon the
nature of the obligation to be met. Factual circumstances that could establish
prospective inability might include that the debtor has a long-term obligation
to make a bond payment that it knows it will not be able to make or that it is
the defendant to a mass tort claim that it knows it cannot successfully defend
and will be unable to pay the associated damages.


     (ii) Types of proceeding that may be commenced
31. A second dimension of the commencement standard is the type of pro-
ceeding that can be commenced (see generally part one, chap. II). In some laws
the commencement standard provides the basis for commencement of either
reorganization or liquidation proceedings. Where a liquidation application is
made by a creditor, the insolvency law may permit the debtor to apply for the
proceedings to be converted from liquidation to reorganization. Under other
insolvency laws where reorganization is favoured, reorganization proceedings
must be commenced, but can be converted to liquidation when it is demon-
strated that the debtor cannot be reorganized. Under a further approach, the
effect of the application is neutral and the choice between reorganization and
liquidation will only be made after a period of assessment of the debtor’s
financial situation.
Part two: I. Application and commencement                                         49


                                  3.   Liquidation
(a)      Persons permitted to apply
32. Insolvency laws generally permit an application for liquidation pro-
ceedings to be made by the debtor, one or more creditors or a government
authority, or by operation of law where the failure by the debtor to meet some
statutory requirement (such as maintenance of a specified level of assets)
automatically triggers insolvency proceedings.

(b)      Debtor application
33. Many insolvency laws adopt a general cessation of payments test for
debtor applications for liquidation. Since, as a matter of practice, an application
by a debtor to commence liquidation proceedings will generally be a last resort
in situations of severe financial difficulty, some laws allow a debtor to make
an application either on the basis that it has ceased to repay its debts as they
become due or, alternatively, on the basis of a simple declaration of its finan-
cial condition, such as that it is unable or does not intend to pay its debts (in
the case of a legal person the declaration may be made by the directors or other
members of a governing body). At least one insolvency law dispenses with the
need for the debtor to allege any particular financial state. In such cases,
whatever burden of proof is placed on the debtor, the insolvency law should
distinguish between, and provide for, on the one hand, situations where accept-
ance of the debtor’s financial declaration can be assumed provided no objec-
tions are raised by creditors and, on the other, situations where the debtor
should be questioned as to its financial circumstances because there is some
doubt regarding its financial situation or because creditors have raised objec-
tions to the commencement of proceedings.

34. To some extent, these issues can be addressed by the procedure for
commencement of proceedings. Where the court is required to make the com-
mencement decision, for example, it will have the opportunity to review the
application and creditors can raise objections at that hearing. Where the appli-
cation functions to automatically commence proceedings, creditors and other
parties in interest will still have the opportunity to raise objections, albeit after
the commencement of proceedings (see below, paras. 55-58, on the decision to
commence; paras. 61-63, on denial of an application; and para. 79, on
dismissal of proceedings). In both cases, attempts to misuse the application
procedure can be reviewed.

   (i)    Establishing an obligation for the debtor to apply
35. A matter related to debtor applications is the question of whether or not
the debtor should have an obligation to apply for commencement of proceed-
ings at a certain stage of its financial difficulty. There is no widely agreed
approach to this issue. Some insolvency or business governance laws include
provisions that require the debtor to apply within a specified period of time
(varying from two weeks to 60 days) after being unable to pay its debts as they
become due or after learning of its overindebtedness determined by reference
50                                                  UNCITRAL Legislative Guide on Insolvency Law


to its balance sheet. Some laws specify how cessation of payments is to be
determined, which may include, for example, by reference to bank records that
show that the debtor has failed to pay a certain percentage of its aggregate
debts for a certain period of time, such as two months. In the case of liquida-
tion, the imposition of such a duty may protect creditors’ interests by prevent-
ing further dissipation of the debtor’s assets and, in the case of reorganization,
increase the chances of success by encouraging early action. This may be
important in countries where there is no active creditor class that can be relied
upon to commence proceedings. Experience in some countries suggests, how-
ever, that imposing an obligation on the debtor to apply after a certain number
of days or weeks of inability to pay or cessation of payments simply leads to
debtor applications that do not reflect a true position of insolvency (and thus
a real need for liquidation or reorganization). In some countries it has also
placed additional strain on the insolvency infrastructure where it may not have
been sufficiently developed to handle a large number of such applications
following the imposition of an obligation of this kind.

36. Establishing such an obligation may also raise difficult practical questions
of how and when it should apply, in particular where a delay in applying for
formal proceedings could lead to personal liability of members of the debtor,
its governing body or its managers. In those circumstances it may operate to
discourage the debtor from pursuing alternative solutions to its financial diffi-
culties, such as a voluntary restructuring agreement, which may be a more
appropriate alternative in particular cases.12 In addition, an obligation to apply
will be of no effect where it is not combined with enforceable (and enforced)
sanctions for the failure to comply. The adoption of incentives (such as the
application of a stay to protect the debtor against enforcement and other
actions—see generally chap. II, paras. 25-73) may be a more effective means
of encouraging debtors to initiate proceedings at an early stage than the impo-
sition of sanctions for failure to meet the obligation to apply.

(c)    Creditor application
37. Many insolvency laws also adopt a cessation of payments requirement for
creditor applications for liquidation of a debtor, often with the additional re-
quirement that a significant portion of the debt be undisputed and free of
offset. In a few laws, the debt must be based upon a court judgement. Where
a test of general cessation of payments is adopted for creditor applications,
problems of proof may arise. While individual creditors may be able to show
that the debtor has failed to pay their own claim or claims, providing evidence
of a general cessation of payments may not be so easy. There is a practical
need for a creditor to be able to present proof, such as by way of a presump-
tion, that establishes the insolvency of a debtor, without placing an unreason-
ably heavy burden of proof on creditors. A presumption that the debtor is
generally unable to pay its debts might be established, for example, where the
debtor fails to pay one or more of its mature debts and the unpaid debt is

      12
         This issue is discussed further in the context of expedited reorganization proceedings and the
relevant commencement criteria, see part two, chap. IV, paras. 76-90.
Part two: I. Application and commencement                                      51


undisputed, that is, not subject to a legitimate dispute or offset. Where the
insolvency law provides such a presumption, there is a corresponding need for
the insolvency law to provide the debtor with an opportunity to rebut the
presumption and specify the grounds upon which it could be rebutted. These
grounds might include the debtor showing that it was able to pay its debts; that
the debt was subject to a legitimate dispute; or any other negation of the
elements by which a creditor established the presumption. Notifying a debtor
of an application for commencement of insolvency proceedings by a creditor
will allow the debtor the opportunity to dispute the creditor’s claims regarding
its financial position (see also below, paras. 64-68, on provision of notice).

38. To refine the test of general cessation of payments in order to establish
a threshold of proof that creditors may satisfy, a reasonably convenient and
objective test may be the failure of a debtor to pay a matured debt within a
specified period of time after a written demand for payment has been made,
or a specified time after the debt became due. A number of insolvency laws
include such provisions with the specified period of time, in those cases where
a formal demand is required, ranging from eight days to 24 weeks. Some
insolvency laws also include provision for the application to be based upon an
unsuccessful debt recovery action that took place within a specified period of
time, such as three months, before the application for commencement is made.
Where time periods are to be included in the law, it may be desirable, in order
to satisfy the key objectives of quick access to insolvency proceedings and
preservation of value, for relatively short periods to be specified.

39. Creditors holding unmatured claims also have a legitimate interest in the
commencement of insolvency proceedings. A particular concern may arise, for
example, in the case of holders of long-term debt. Where the commencement
test is based on mature debt, those creditors might never be eligible to apply
for commencement of proceedings, although it may be clear that the debtor
will be unable to meet the relevant obligation when the date of maturity of the
debt approaches. One solution might be for an insolvency law to provide that
the failure to pay an instalment of long-term debt could form the basis of a
creditor application. However, developing a test that would allow an appli-
cation in those circumstances may raise difficult issues of proof, in particular
as to how the failure to make a single payment relates to the debtor’s overall
financial status. If an insolvency law were to permit applications to be made
by creditors not holding mature debt, those issues of proof would need to be
balanced against the objective of convenient, cost-effective and quick access
to insolvency proceedings. These issues could be addressed by using a
standard that contains both the cessation of payments and balance sheet tests.

40. In addition to the requirements for cessation of payments, maturity of the
debt and that the claim be undisputed, some insolvency laws include other
requirements, for example that the application must be made by more than one
creditor (each of which may be required to be an unsecured creditor holding an
undisputed claim); and that creditors not only hold mature claims, but that their
claims represent a specified composite value of claims (or a combination of both
a specified number or percentage of creditors and a composite value of claims).
52                                       UNCITRAL Legislative Guide on Insolvency Law


41. These requirements are often based upon the desire to minimize possible
improper use by a single creditor who may seek to use insolvency proceedings
as a substitute for a debt enforcement mechanism, in particular where the debt
in question is small, or by a small number of creditors whose debt is only a
fraction of the debtor’s total indebtedness. The arguments in favour of such an
approach may need to be balanced, however, against the objective of facili-
tating quick and easy access to insolvency proceedings. The concerns with
improper use may be addressed by taking into account the value of the claim
of the single creditor (although specifying a particular value for claims may not
always be an optimal drafting technique as currency fluctuations may neces-
sitate amendment of the law) or adopting a procedure that requires the debtor
to provide information to the court that will enable the court to determine
whether non-payment of a debt is the result of a dispute with a particular
creditor or is, in fact, evidence of a lack of liquid assets. Concerns with
improper use can also be addressed by focusing on discouraging improper use,
rather than upon constructing a complex commencement standard to the poten-
tial detriment of all eligible debtors, and providing for certain consequences,
such as denial of the application and damages for harm done to the debtor.
These damages may relate not only to the costs and expenses incurred by the
debtor, but also to disruption to the debtor’s business.


(d)   Application by a government authority
42. Where the Government is a creditor, it should have the same right as any
other creditor to initiate liquidation proceedings. That right is generally given
to a specific government department or agency (normally the public prose-
cutor’s office or the equivalent) or other supervisory authority and the same
commencement standard as applies in the case of applications by other
creditors should generally apply.

43. Some countries provide an additional more broadly based power for
government or other supervisory authorities to use the insolvency regime to
shut down a business in circumstances where the authority is not necessarily
a creditor but closure of the business is considered to be in the public interest.
In that case, a demonstration of illiquidity is not always necessary, enabling the
Government to terminate the operations of businesses that have been engaged
in certain activities, generally of a fraudulent or criminal nature or involving
serious breach of regulatory obligations or a combination of these. Given the
potential for such a power to be misused in circumstances unrelated to
insolvency and for public interest grounds to be very broadly defined, it is
highly desirable that such powers be available only in very limited circum-
stances and only as a last resort in the absence of appropriate remedies under
other laws. These limited circumstances may include the use of insolvency
powers in conjunction with enforcement of laws, such as laws relating to
money-laundering or regulation of securities, where a demonstration of insol-
vency may not be required. They may also include circumstances involving
actual indications of insolvency where, for example, the authority is acting in
the interests of a large number of small creditors, none of whom has a large
Part two: I. Application and commencement                                       53


enough debt to justify applying for proceedings, but who are nevertheless
being harmed by the activities of the debtor.
44. Certain protections may also be required where the insolvency regime is
to be used in these ways. For example, a preliminary investigation of the
affairs of the debtor may be required; and preliminary measures, such as
application of a stay and appointment of an interim insolvency representative,
may be granted to prevent the possibility of impropriety pending the court’s
determination as to what further action should be taken with respect to the
business. The additional powers discussed above would generally only be
available to commence liquidation proceedings, although there may be excep-
tional circumstances where liquidation could be converted to reorganization,
subject to certain conditions. These conditions might include that the business
activity is lawful and that management of the debtor’s business is taken over
by an insolvency representative or governmental agency.

                                4.   Reorganization
(a)   Parties who may apply
45. To a greater extent than with applications to commence liquidation pro-
ceedings, insolvency laws take different approaches to the parties that may
apply to commence reorganization proceedings. While some laws allow appli-
cations by both debtor and creditors, a number of laws only permit debtor
applications.

(b)   Debtor application
46. One of the objectives of reorganization proceedings is to establish a
framework that will encourage debtors to address their financial difficulties at
an early stage to enable the business to continue to the benefit of the debtor
and creditors alike. A commencement standard that is consistent with that
objective may be one that is more flexible than the commencement standard
for liquidation and does not require the debtor to wait until it has ceased
making payments generally before making an application, but allows an appli-
cation in financial circumstances that, if not addressed, will result in a state of
insolvency. Approaches to debtor applications for reorganization vary between
insolvency laws. In some laws, the reorganization procedure does not actually
require the satisfaction of any substantive standard: the debtor may make an
application whenever it wishes and is only required to file a simple petition in
the appropriate court. Other laws, including those which adopt a unitary ap-
proach (see part one, chap. I, paras. 21-25), specify that the debtor may make
an application if it envisages that, in the future, it will not be in a position to
pay its debts when they come due (prospective or imminent insolvency or
illiquidity). A number of reorganization laws also require evidence of a real or
reasonable prospect of survival of the debtor or of the economic viability of the
debtor’s business.
47. It might be suggested that a relaxation of the commencement standard
could invite abuse of insolvency proceedings. For example, a debtor that is not
54                                        UNCITRAL Legislative Guide on Insolvency Law


in financial difficulty might apply to commence proceedings and submit a
reorganization plan that is designed to allow it to shed onerous obligations,
such as labour contracts, to allow it to renegotiate its debt or to prevaricate and
deprive creditors of prompt payment of debts in full. These situations should
be distinguished from those situations in which debtors should be encouraged
to apply because, for example, the payment of mature debts caused financial
hardship that could lead to insolvency in the future (see above, para. 30, on
imminent insolvency), even if the debtor was not actually insolvent at the time
the application was made. In other words, there is a financial basis for the
application. Whether such improper use could arise is a question of how the
elements of the reorganization procedure are designed, including the com-
mencement standard, requirements for preparation of the reorganization plan,
debtor control of the business after commencement and sanctions for improper
use of the proceedings. As noted above, it may be desirable that the insolvency
law focuses upon discouraging improper use rather than making commence-
ment more difficult to the potential detriment of all eligible applicants. Im-
proper use by the debtor could be addressed by providing, for example, that
the relevant court has the power to deny the application and, in that event, that
the debtor should be liable to creditors for their costs associated with resisting
the application and for any harm caused by the application.

(c)   Creditor application
48. Although insolvency laws generally provide for liquidation proceedings
to be initiated by either a creditor or a debtor, there is no consensus as to
whether reorganization proceedings can also be initiated by a creditor. As
noted above, a number of laws include provision only for debtor applications.
Given that one of the objectives of reorganization proceedings is to enhance
the value of assets and thereby increase the return to creditors on their claims
through the continued operation and reorganization of the debtor’s business, it
is highly desirable that the ability to apply not be given exclusively to the
debtor. A further reason for allowing creditor applications is that there will be
cases where the debtor will not or cannot apply for commencement because,
for example, management has resigned. The ability of creditors to apply for
reorganization is also central to the question of whether creditors can propose
a reorganization plan (see chap. IV, paras. 8-14) and may significantly influ-
ence their support for any plan proposed. A number of countries take the
position that, since in many cases creditors are the primary beneficiaries of a
successful reorganization, creditors should have an opportunity to propose the
plan. If that reasoning is followed, it seems reasonable to permit creditors to
apply for commencement of reorganization proceedings.

49. Insolvency laws that permit creditors to apply for reorganization of a
debtor take different approaches to the commencement standard. One approach
is those insolvency laws which use the same test, including prospective
illiquidity, as applies in the case of a debtor application for reorganization. A
different approach regards use of the same test, especially the inclusion of
prospective illiquidity, as difficult to justify. This is not only because of the
difficulties associated with creditors being able to prove that a standard of
Part two: I. Application and commencement                                                         55


prospective illiquidity has been met by the debtor, but rather because, as a
general matter, it would seem unreasonable for any form of insolvency
proceeding to be commenced against the debtor’s will, unless creditors can
demonstrate that their rights already have been impaired.

50. To address these issues with respect to creditor commencement of
reorganization proceedings, some laws adopt commencement standards that
require creditors to demonstrate certain factors in addition to the debtor’s
insolvency. For example, they must show that ongoing cash will be available
to pay for the day-to-day running of the business, that the value of the assets
will support reorganization and that the return to creditors in reorganization is
likely to exceed the return in liquidation. One clear disadvantage of such an
approach is that it requires creditors to have made, or be able to make, a
thorough assessment of the debtor’s business before making an application. To
make that assessment, however, creditors must be able to obtain information
from the debtor that is relevant to that assessment and reliable enough to
facilitate the assessment. To assist in such situations, an insolvency law can
provide, for example, that on an application by creditors, an assessment of the
debtor’s financial situation will be undertaken by an independent authority.
Such a procedure may help to ensure that proceedings are only commenced in
appropriate cases. Care may be needed to ensure, however, that the additional
requirements do not serve to complicate the application procedure, discourag-
ing creditors from proposing reorganization and promoting liquidation as an
easier alternative or delaying commencement of the proceedings with conse-
quences for maximization of value of the assets and the likelihood of success-
ful reorganization. Care should also be taken to ensure that the insolvency
context is not used by a competitor of the debtor to obtain commercially
sensitive or confidential information or to disrupt the debtor’s business by
imposing unjustifiable requirements with regard to assessment of its financial
position.

51. Some insolvency laws adopt a variation of the cessation of payments test
and require the application to be made by a specified number of creditors or
by creditors holding a specified value of matured claims, or both. Other laws
require creditors, on making an application, to provide a bond or payment to
cover the costs of the commencement proceedings.13 These requirements might
be said to suffer from the same disadvantages as noted above in respect of
requirements that creditors must show sufficient means are available to achieve
a successful reorganization.

52. The question of the complexity or simplicity of commencement standards
is closely linked to the consequences of commencement and the conduct of the
insolvency proceedings. In insolvency laws that apply a stay automatically on
commencement of the proceedings, for example, the ability of the business to
continue trading and be successfully reorganized can be assessed after com-
mencement (and, where the law permits, the proceedings can be converted to

      13
        Such a payment may also provide remuneration for the insolvency representative (see part two,
chap. III, para. 58, and also the discussion on fees for insolvency proceedings below, paras. 76-78).
56                                       UNCITRAL Legislative Guide on Insolvency Law


liquidation if reorganization is determined to be inappropriate). In other
systems, that information may be needed before an application is made
because the choice of reorganization presupposes that it will lead to a greater
return for creditors than liquidation.

53. For the reasons discussed in the paragraphs above, it may be appropriate
to apply the same commencement standard to applications by creditors for both
liquidation and reorganization of a debtor (i.e. a general cessation of payments
test). Such a standard would appear to be consistent with both the two-track
approach and the unitary approach (see part one, chap. I, para. 25), where the
use of a different commencement standard is a function not so much of the
type of proceeding being initiated, but rather of whether the applicant is the
debtor or a creditor. The exception to the approach of having the same
commencement standard for both liquidation and reorganization would be
those systems which favour reorganization and where both a debtor and a
creditor are precluded from initiating liquidation proceedings until it has been
determined that reorganization is impossible. In that case, the commencement
standard for liquidation would not be a general cessation of payments, but
rather a determination that reorganization cannot succeed.

                           5.   Procedural issues
(a)   Making an application for commencement
54. The insolvency law should specify the procedural requirements for
making an application. Many insolvency laws require an application to be filed
with a specified court, although there are other examples such as a law that
provides for the proceedings to be initiated by the debtor lodging a declaration
with the corporate regulatory authority. The issue of procedural requirements
raises the question of the involvement of the court in insolvency proceedings
more generally, which is discussed in part one (see above, chap. III, paras. 1-8,
on institutional framework). Law other than the insolvency law may also affect
the way in which insolvency proceedings are commenced, such as constitu-
tional law (which may be relevant, for example, to the role of courts and
administrative agencies and to issues of competence), procedural law (includ-
ing court rules) or company law.

(b)   The decision to commence insolvency proceedings
55. A preliminary procedural issue relates to the manner in which the pro-
ceedings commence once the application has been made. In many States the
normal practice is for a court of competent jurisdiction to determine, on the
basis of the application, whether the requisite conditions for commencement
have been met. In some States, that determination can also be made by the
appropriate administrative agency or tribunal, where that agency plays a cen-
tral supervisory role in the insolvency proceedings. The central issue, however,
is not so much who makes the decision to commence proceedings but rather
what that body is required to do in order to approve an application and for
proceedings to commence.
Part two: I. Application and commencement                                      57


56. Entry conditions that are designed to facilitate early and easy access to
insolvency proceedings not only will facilitate the consideration of the appli-
cation by the court or other body by reducing complexity and, where appro-
priate, assisting it to reach a decision in a timely manner, but also have the
potential to reduce the cost of proceedings and increase transparency and pre-
dictability. Such entry conditions are also less likely to place a burden on
systems, which may lack institutional capacity or the expertise to undertake
complex investigations requiring considerable commercial and business exper-
tise. The issue of the costs and fees associated with accessing insolvency
proceedings may be of particular importance in the case of small- and medium-
size businesses. A further factor to be noted with respect to the commencement
procedure is a recent trend in several insolvency laws of recognizing that the
debtor has a fundamental right to be heard by the court or body that would
determine an application for commencement of proceedings, whether the
application was made by the debtor or by creditors.

57. In addressing requirements for commencement, some insolvency laws
draw a distinction between an application by a debtor and an application by a
creditor. In some laws, an application by a debtor functions as an acknowl-
edgement of insolvency and leads to an automatic commencement of proceed-
ings, unless it can be shown that the insolvency law is being abused by the
debtor. In contrast, in the case of an application by a creditor under these laws,
a court is required to consider whether the commencement criteria have been
met before deciding to commence the proceedings. A primary reason is to
avoid abuse by creditors or other parties in interest. The debtor would have
various courses of action open to it, including consenting to the application,
disputing the applicant’s claim as to its financial position and requesting the
commencement of different proceedings (e.g. where the application is for
liquidation, requesting commencement of reorganization). The debtor may also
have jurisdictional or procedural defences to a creditor application. In some
other laws, irrespective of whether the application is made by a debtor or
creditors, the court is required to determine not only whether the entry condi-
tions have been met, but also whether the type of proceeding applied for is
appropriate to the particular circumstances of the debtor.

58. If the assessment to be made is complex there is a potential not only for
delay between application and commencement, but also for further debts to be
incurred in that period, as the debtor continues to trade and allows trade debts
to increase in order to preserve cash flow, and for assets to be dissipated by
the actions of creditors. Where the court is required to assess various issues
before proceedings can be commenced, one means of reducing the potential
complexity of the assessment is to provide, firstly, for the assessment to be
made after commencement when the court can be assisted by the insolvency
representative and other experts and, secondly, for conversion between liqui-
dation and reorganization. Where this approach is adopted, an insolvency law
may need to provide clear rules regarding the application of the stay (see
generally chap. II, paras. 25-73), priority for repayment of debts incurred (see
chap. V, para. 66) and the debtor’s authority to dispose of assets between
application and commencement (see chap. II, paras. 16 and 70-73), as well as
58                                        UNCITRAL Legislative Guide on Insolvency Law


the treatment of unauthorized transactions occurring during the assessment
period (see chap. II, para. 147).

(c)   Establishing a time limit for making the commencement decision
59. Where a court is required to make a decision as to commencement, it is
desirable that that decision be made in a timely manner to ensure both certainty
and predictability of the decision-making and the efficient conduct of the pro-
ceedings without delay. This will be particularly important in the case of
reorganization to avoid further diminution of the value of assets and to
improve the chances of a successful reorganization. Some insolvency laws
prescribe set time periods after the application within which the decision to
commence must be made. These laws often distinguish between applications
by debtors and by creditors, with applications by debtors tending to be deter-
mined more quickly. Any additional period for creditor applications is
designed to allow prompt notice to be given to the debtor and provide the
debtor with an opportunity to respond to the application.

60. Although the approach of fixing time limits may serve the objectives of
providing certainty and transparency for both the debtor and creditors, the
achievement of those objectives may need to be balanced against possible
disadvantages. For example, a fixed time period may be insufficiently flexible
to take account of the circumstances of the particular case. More generally,
such time periods may be set without regard to the resources available to the
body responsible for supervising insolvency proceedings or of the local priori-
ties of that body (especially where insolvency is only one of the matters for
which it has responsibility). It may also prove difficult to ensure that the
decision-making body adheres to the established limit and to provide appropri-
ate consequences where there is no compliance. The time period between
application and the decision to commence proceedings should also reflect the
type of proceeding applied for, the application procedure and the consequences
of commencement in any particular regime. For example, the extent to which
notification of parties in interest and information gathering must be completed
prior to commencement will vary between regimes, requiring different periods
of time. For these reasons, it is desirable that an insolvency law adopt a flexible
approach that emphasizes the advantages of quick decision-making and pro-
vides guidance as to what is reasonable, but at the same time also recognizes
local constraints and priorities.

(d)   Denial of an application to commence proceedings
61. The preceding paragraphs refer to a number of instances where it will be
desirable, in those cases where the court is required to make the commence-
ment decision, for the court to have the power to deny the application for
commencement, either because of questions of improper use of the insolvency
law or for technical reasons relating to satisfaction of the commencement
standard. The cases referred to include examples of both debtor and creditor
applications. Principal among the grounds for denial of the application for
technical reasons might be those cases where the debtor is found not to satisfy
Part two: I. Application and commencement                                      59


the commencement standard; where the debt is subject to a legitimate dispute
or off-set in an amount equal to or greater than the amount of the debt; where
the proceedings will serve no purpose because, for example, secured debt
exceeds the value of assets; and where the debtor has insufficient assets to pay
for the insolvency administration and the law makes no other provision for
funding the administration of such estates.

62. Examples of improper use might include those cases where the debtor
uses an application for insolvency as a means of prevaricating and unjustifiably
depriving creditors of prompt payment of debts or of obtaining relief from
onerous obligations, such as labour contracts. In the case of a creditor appli-
cation, it might include those cases where a creditor uses insolvency as an
inappropriate substitute for debt enforcement procedures (which may not be
well developed); to attempt to force a viable business out of the market place;
or to attempt to obtain preferential payments by coercing the debtor (where
such preferential payments have been made and the debtor is insolvent, investi-
gation would be a key function of insolvency proceedings).

63. As noted above, where there is evidence of improper use of the insol-
vency proceedings by either the debtor or creditors, the insolvency law may
provide, in addition to denial of the application, that sanctions can be imposed
on the party improperly using the proceedings or that that party should pay
costs and possibly damages to the other party for any harm caused. Remedies
may also be available under non-insolvency law. Where an application is
denied, any provisional measures of relief ordered by the court after the time
of the application for commencement should terminate (see chap. II, para. 53).

(e)         Notice of application and commencement
64. Giving notice of an application for commencement and of the commence-
ment of insolvency proceedings is central to several key objectives of an
insolvency regime. It ensures the transparency of the proceedings and that all
affected parties—the creditors and parties in interest in the case of a debtor
application, and the debtor and other creditors and parties in interest the case
of a creditor application—are equally well informed.

      (i)    Debtor applications: notice to creditors
65. In the event of a debtor application, creditors and other parties in interest
have a direct interest in receiving notice of the proceedings and an opportunity
to dispute the presumptions of eligibility (perhaps within a specified time
period to prevent the proceedings from being prolonged unnecessarily). The
question arises, however, as to the time at which creditors should be notified—
at the time the application is made or the time the proceedings commence.
Creditors will have an interest in being notified of the application in order to
be able to make an informed decision concerning continuing provision of
goods and services to the debtor to avoid the accumulation of further debt. A
delay between application and commencement could have serious conse-
quences for creditors who continue to trade with the debtor, unaware of its
60                                       UNCITRAL Legislative Guide on Insolvency Law


financial difficulties. The interests of creditors in knowing that the application
has been made may need to be balanced, in certain circumstances, against the
possibility that, if notice of the application is provided, the business position
of the debtor may be unnecessarily affected where the application is ultimately
rejected or creditors may be encouraged to take last-minute action to enforce
their claims. These concerns may be addressed by providing generally that
creditors and other parties in interest will be notified only of commencement
of the proceedings and adopting a commencement procedure that avoids un-
necessary delay between application and commencement.

66. A further consideration is whether to expressly address foreign creditors
in any notification requirements included in an insolvency law, to ensure the
equal treatment of domestic and foreign creditors and to take account of the
international trend of abolishing discrimination based upon the nationality of
the creditor. The factors to be balanced in determining that issue are discussed
below in the context of the manner of giving notice.

     (ii) Creditor application: notice to the debtor
67. In the event of a creditor application for commencement of insolvency
proceedings, it is increasingly recognized that the debtor should have a funda-
mental right to immediate notice of the application and an opportunity to be
heard and to dispute the applicant’s claims as to its financial position (see
chap. III, paras. 20 and 21). Where the debtor has disappeared or is avoiding
receiving personal notice, requirements for public notification might suffice or
notice could be served at the last known address of the debtor. Nevertheless,
there may be exceptional circumstances where provision could be made, with
the consent of the court, for personal notice to the debtor to be dispensed with
on the basis that it may thwart the purpose of a particular application. These
circumstances may include cases where giving notice of the application may
lead to assets being placed by the debtor beyond the reach of the creditors or
the insolvency representative. The counter-argument is that, where the debtor
is not notified, it could unknowingly continue to act to the detriment of the
value of its assets and thus its creditors. This concern may be better addressed
in terms of provisional measures such as the imposition of a stay than by
dispensing with notice of the application. However, where the law does permit
the court to dispense with notice of the application, the debtor should never-
theless receive notice of commencement of proceedings as soon as possible.
Creditors other than those applying for commencement of proceedings may
have a direct interest in being notified of the commencement of those proceed-
ings.

     (iii) Notice of commencement to parties other than creditors
68. There may be a number of parties other than creditors who will require
notice of the commencement of proceedings. These parties may include the
postal administration (especially where the law requires mail for the debtor to
be delivered to the insolvency representative), tax authorities, social service
authorities and corporate regulators.
Part two: I. Application and commencement                                                          61


   (iv) Manner of giving notice
69. In addition to the question of the time at which notice is to be given, an
insolvency law may need to address, in order to ensure the effectiveness of the
notice, the manner in which notice is given and the information to be included.
The manner of giving the notice could address both the party required to give
the notice (e.g. the court or the party making the application for commence-
ment) and how the information can be made available, with the key considera-
tion being delivery or publication in a form that is generally likely to come to
the notice of parties in interest. For example, while known creditors14 may be
notified individually (the effectiveness of this method will depend upon the
state of the debtor’s records), the need to inform unknown creditors has led
legislators to adopt broad requirements, such as publication in an official
government publication or a commercial or widely circulated newspaper. That
newspaper may be regional, national or local (by reference to the location of
the debtor’s business), depending upon the circumstances of the case and what
will prove to be most cost-effective. It may not always be necessary, for
example, to require publication at considerable expense in a national news-
paper when the debtor’s business is based and conducted locally.

70. To avoid the notification procedure becoming unwieldy and requiring in
each case an investigation into what will prove to be the most effective means
of giving notice, the obligation should refer to standard forms, with some
flexibility for local conditions. Other options for achieving effective noti-
fication may include various forms of electronic communication and use of
relevant public registries.

   (v) Content of the notice
71. The information required in the notice may include the effect of the com-
mencement of proceedings (especially as to the application of the stay—see
chap. II, sect. B); the time for submission of claims; the manner in which
claims should be submitted and the place at which they should be submitted;
the procedure and any form requirements necessary for submitting a claim;
advice as to which creditors should make claims (i.e. whether secured creditors
need to submit a claim—see chap. V, paras. 2-5—and any special provisions
applicable to foreign creditors); consequences of failure to make a claim or to
make a claim in the prescribed manner; and information concerning verifica-
tion of claims and meetings of creditors.

                         6. Debtors with insufficient assets
72. Many debtors that would satisfy the criteria for commencement of insol-
vency proceedings are never formally liquidated, either because creditors are
reluctant to initiate proceedings where it appears that the debtor has no, or

      14
        This will be facilitated by reference to the list of creditors to be provided by the debtor in
cooperation with the insolvency representative (see chap. III, paras. 23-27 and 49-51; also art. 14,
UNCITRAL Model Law (see annex III).
62                                        UNCITRAL Legislative Guide on Insolvency Law


insufficient, assets to fund the administration of insolvency proceedings or
because debtors in such a position will rarely take steps to commence proceed-
ings. Some insolvency laws provide that where an application for commence-
ment is made in these circumstances, it will be denied on the basis of an
assessment of insufficiency of assets by the court, while others provide a
mechanism for appointment and remuneration of an insolvency representative
(see chap. III, paras. 44-47). Some other laws provide for a surcharge on
creditors to pay for the administration of estates (see paras. 76-78, on fees,
below).

73. There are a number of reasons, in particular of a public interest nature, for
devising a mechanism to enable the administration of a debtor with apparently
few or no assets under a formal proceeding. Where an insolvency law does not
provide for exploratory investigations of insolvent companies with few or no
assets, it does little to ensure the observance of fair commercial conduct or to
further standards of good governance of commercial entities. Assets can be
moved out of companies or into related companies prior to liquidation with no
fear of investigation or the application of avoidance provisions or other civil
or criminal provisions of the law.

74. A mechanism for administration will assist in overcoming any perception
that such abuse is tolerated and may provide a return for creditors where
antecedent transactions can be avoided, as well as a means of investigating the
conduct of the management of such debtors. It may also encourage entrepre-
neurial activity and responsible economic risk-taking through the provision of
a discharge and fresh start for entrepreneurs and others engaging in economic
activities—the punitive and deterrent aspects of insolvency laws will be less
appropriate where the debtor is honest. For example, where an application to
commence insolvency proceedings might otherwise be denied, some insol-
vency laws provide an exception for individuals with insufficient assets to fund
the administration of proceedings, enabling the affairs of that debtor to be
investigated to determine if there are assets that can be recovered and whether
the debtor should receive a discharge.

75. Mechanisms for pursuing the administration of such estates may include,
as noted above, levying a surcharge on creditors to fund administration; estab-
lishing a public office or utilizing an existing office; establishing a fund out of
which the costs may be met; or appointing a listed insolvency professional on
the basis of a roster or rotation system. The latter systems are generally
designed to ensure a fair and ordered distribution of all insolvency cases,
whether with insufficient assets or otherwise, where the insolvency representa-
tive will be paid a prescribed stipend by the State or the costs will be borne
directly by the insolvency representative and cross-subsidized by their clients
generally (since, where they are a professional, their remunerative rates can be
adjusted to take into account unremunerative work—this approach could not
be taken where the insolvency representative is a government official). Where
such a mechanism is included in an insolvency law, consideration may also
need to be given to defining those debtors to which the provisions will
apply, for example, debtors having available less than a prescribed value of
Part two: I. Application and commencement                                     63


unencumbered assets (not including those assets which natural person debtors
are allowed to retain—see chap. II, paras. 18-21) and no regular source of
revenue that would otherwise enable the liquidation to proceed.

                     7.   Fees for insolvency proceedings
76. Cost-effectiveness, in addition to speed and efficiency, is an important
aspect of an effective insolvency regime and one that bears upon all phases of
the insolvency proceedings. It is thus important, when designing an insolvency
law, to avoid the situation where the proceedings are subject to cost burdens
that will deter creditors, discourage commencement and frustrate the basic
objectives of the proceedings. This is of particular importance in the case of
insolvency of small and medium-size businesses. It may also be important
where, for example, the debtor has a large debt that comprises a number of
smaller creditors whose individual debts might not support the costs of the
application procedure or where the estate has few assets.
77. Applications by both debtors and creditors for commencement of insol-
vency proceedings may be subject to the payment of fees. Different approaches
may be taken to the level of fee imposed. One approach might be to set a fee
that can be used to help defray the costs of the proceedings. Where the result-
ant fee is high, however, it could operate as a deterrent and run counter to the
objective of convenient, cost-effective and quick access to insolvency proceed-
ings. A very low fee, on the other hand, might not be sufficient to deter
frivolous applications and it is therefore desirable that a balance between these
objectives be reached.
78. Some insolvency laws require creditors making an application to guaran-
tee the payment of the costs of the proceedings up to a certain fixed amount,
to pay a certain percentage of the total of claims or to pay a fixed amount as
a guarantee for costs. In some laws where a payment as security for costs is
required, that amount may be refunded from the estate if there are sufficient
assets and certain creditors, such as employees, are exempted from providing
the required security. Other laws require, as a condition of commencement,
that the unencumbered assets of the estate must be sufficient to cover the costs
of the proceedings. Where they are insufficient, the insolvency law generally
provides for the application to be denied (which may result in the debtor’s
financial situation remaining unresolved) or for it to be treated in accordance
with provisions on estates with few or no assets (see above). A further
approach establishes the fees that may be levied as a fixed percentage of the
value of the assets of the estate. In large cases, this may result in significant
fees being paid out of the estate, discouraging both creditor and debtor
applications.

     8.   Dismissal of insolvency proceedings after commencement
79. In addition to circumstances where the application to commence proceed-
ings might be denied as discussed above (paras. 61-63), there will also be
instances where, after proceedings have already commenced, an insolvency
64                                                 UNCITRAL Legislative Guide on Insolvency Law


law should permit them to be dismissed. A dismissal procedure will be relevant
to an insolvency law irrespective of whether an application by the debtor
functions to automatically commence proceedings or the decision to com-
mence is made by the court. In either situation, information relevant to dis-
missal may become available at some later stage of the proceedings or circum-
stances may change. The grounds for dismissal would be essentially the same
as those for denial, that is, that there is improper use of the insolvency law,
either by the debtor or creditors, or that the debtor did not satisfy the com-
mencement criteria at the time of commencement.



                                    Recommendations 14-29
     Purpose of legislative provisions
          The purpose of provisions on commencement of insolvency proceedings is:
          (a) To facilitate access for debtors and creditors to the remedies provided
     by the law;
          (b) To establish commencement criteria that are transparent and certain;
          (c) To enable applications for insolvency proceedings to be made and
     dealt with in a speedy, efficient and cost-effective manner;
          (d) To establish safeguards to protect both debtors and creditors from
     improper use of the application procedure; and
          (e) To establish requirements for effective notification of commence-
     ment of proceedings.

     Contents of legislative provisions
     Commencement standard
           Persons permitted to apply (paras. 32-53)
          14. The insolvency law should specify the persons permitted to make an
     application for commencement of insolvency proceedings, which should in-
     clude the debtor and any of its creditors.15

           Debtor application (paras. 33-36 for liquidation and 45-47
           for reorganization)
          15. The insolvency law should specify that insolvency proceedings can
     be commenced on the application of a debtor if the debtor can show either that:
          (a) It is or will be generally unable to pay its debts as they mature; or
          (b) Its liabilities exceed the value of its assets.16


      15
        This would include a government authority that is a creditor of the debtor.
      16
        The intention of this recommendation and the recommendation on creditor applications is to
allow legislators flexibility in developing commencement standards, based on a single or dual test
approach. Where the insolvency law adopts a single test, it should be based on the debtor’s inability
to pay debts as they mature (cessation of payments test) and not on the balance sheet test. Where the
insolvency law contains both tests (cessation of payments and balance sheet tests), proceedings can
be commenced if one of the tests can be satisfied.
Part two: I. Application and commencement                                                               65



        Creditor application (paras. 37-41 for liquidation and 48-53
        for reorganization)
         16. The insolvency law should specify that insolvency proceedings can
     be commenced on the application of a creditor if it can be shown that either:
           (a) The debtor is generally unable to pay its debts as they mature; or
           (b) The debtor’s liabilities exceed the value of its assets.

     Presumption that the debtor is unable to pay (para. 37)
           17. The insolvency law may establish a presumption that, if the debtor
     fails to pay one or more of its mature debts, and the whole of the debt is not
     subject to a legitimate dispute or offset in an amount equal to or greater than
     the amount of the debt claimed, the debtor is generally unable to pay its debts.17

     Commencement on debtor application (para. 65)
        18. The insolvency law should specify that where the application for
     commencement is made by the debtor:
          (a) The application for commencement will automatically commence the
     insolvency proceedings; or
         (b) The court will promptly determine its jurisdiction and whether the
     debtor is eligible and the commencement standard has been met and, if so,
     commence insolvency proceedings.

     Commencement on creditor application (paras. 57 and 67)
          19. The law generally should specify that, where a creditor makes the
     application for commencement:
           (a) Notice of the application promptly is given to the debtor;18
          (b) The debtor be given the opportunity to respond to the application, by
     contesting the application, consenting to the application or, where the applica-
     tion seeks liquidation, requesting the commencement of reorganization pro-
     ceedings; and
         (c) The court will promptly determine its jurisdiction and whether the
     debtor is eligible and the commencement standard has been met and, if so,
     commence insolvency proceedings.19



       17
         Where the debtor has not paid a mature debt and the creditor has obtained a judgement against
the debtor in respect of that debt, there would be no need for a presumption to establish that the debtor
was unable to pay its debts. The debtor could rebut the presumption by showing, for example, that
it was able to pay its debts; that the debt was subject to a legitimate dispute or offset; or that the debt
was not mature. The recommendations on notice of commencement provide protection for the debtor
by requiring notice of the application for commencement of proceedings to be given to the debtor and
providing the debtor with an opportunity to rebut the presumption.
       18
         Where the debtor’s whereabouts is unknown and it cannot be contacted, the general law may
provide relevant rules concerning the giving of notice in such circumstances.
       19
         A determination that the commencement standard has been met may involve consideration of
whether the debt is subject to a legitimate dispute or offset in an amount equal to or greater than the
amount of the debt. The existence of such a set-off may be a ground for dismissal of the application
(see above, paras. 61-63).
66                                                    UNCITRAL Legislative Guide on Insolvency Law




     Recommendations 14-29 (continued)
     Denial of an application to commence proceedings (paras. 61-63)
          20. The insolvency law should specify that, where the decision to com-
     mence proceedings is to be made by the court, the court may deny the appli-
     cation to commence and, where appropriate, impose costs or sanctions against
     the applicant, if it determines that:
         (a) It does not have jurisdiction or the debtor is ineligible or does not
     meet the commencement standard; or
           (b) The application is an improper use of the law.

         21. Where the application was made by a creditor, the insolvency law
     should specify that the debtor promptly be given notice of the decision to deny.

     Notice of commencement of proceedings (paras. 64-71)
          22. The insolvency law should establish procedures for giving notice of
     the commencement of insolvency proceedings.

        General notice (paras. 69 and 70)
          23. The insolvency law should specify that the means of giving notice of
     the commencement of insolvency proceedings must be appropriate20 to ensure
     that the information is likely to come to the attention of parties in interest.21
     The insolvency law should specify the party responsible for giving that notice.

        Notice to creditors (paras. 65 and 66)
          24. The insolvency law should specify that notice of the commencement
     of proceedings is to be given to creditors individually, unless the court con-
     siders that, under the circumstances, some other form of notice would be more
     appropriate.22

        Content of the notice (para. 71)
          25. The insolvency law should specify that the notice of commencement
     of insolvency proceedings is to include:
          (a) Information concerning submission of claims, including the time and
     place for submission;
           (b) The procedure and form requirements for the submission of claims;


       20
          The question of what is appropriate in a particular case will also involve considerations of
cost-effectiveness and the insolvency law should not require, for example, expensive publication in
a national newspaper, when publication in a local paper will suffice.
       21
          General notice would generally be provided by way of making the information available in
a publication such as an official government gazette, a widely circulated national, regional or local
newspaper, through electronic means or through relevant public registries.
       22
          The obligation to prepare the list of creditors to be given notice is dealt with under obligations
of the insolvency representative and the debtor (see chap. III, paras. 22-27 and 49-51).
Part two: I. Application and commencement                                                       67




         (c) The consequences of failure to submit a claim in accordance with
     paragraphs (a) and (b) above; and
         (d) Information concerning verification of claims, application of the stay
     and its effects and meetings of creditors.

     Debtors with insufficient assets (paras. 72-75)
          26. The insolvency law should specify the treatment of debtors whose
     assets and sources of revenue are insufficient to meet the costs of administer-
     ing the insolvency proceedings. Different approaches may be taken, including:
        (a) Denial of the application, except where the debtor is an individual
     who would be entitled to a discharge; or
          (b) Commencement of the proceedings, where different mechanisms for
     appointment and remuneration of the insolvency representative may be
     available.23

     Dismissal of insolvency proceedings after commencement (para. 79)
          27. The insolvency law should permit the court to dismiss proceedings if,
     after commencement, the court determines, for example, that:
          (a) The proceedings constitute an improper use of the insolvency law; or
          (b) The debtor was ineligible or did not meet the commencement
     standard at the time of commencement.

          28. The insolvency law should specify that, where proceedings are dis-
     missed, the court may impose costs or sanctions, where appropriate, against
     the applicant for commencement of the proceedings.

         29. The insolvency law should require notice of a decision to dismiss
     proceedings to be given.




              C.     Applicable law in insolvency proceedings*
                                      1.   Introduction
80. Where insolvency proceedings involve parties or assets located in differ-
ent States, complex questions may arise as to the law that will apply to ques-
tions of validity and effectiveness of rights in those assets or of other claims;
and to the treatment of those assets and of the rights and claims of those
foreign parties in the insolvency proceedings. In the case of such insolvency
proceedings, the forum State will usually apply its private international law

       23
         On mechanisms for appointment, see chap. III, paras. 44-47; on remuneration, chap. III,
paras. 53-59.
       *The present section was developed in close cooperation with the Hague Conference on Private
International Law.
68                                        UNCITRAL Legislative Guide on Insolvency Law


rules (or conflict of laws rules) to determine which law is applicable to the
validity and effectiveness of a right or claim and to their treatment in the
insolvency proceedings. The UNCITRAL Model Law on Cross-Border Insol-
vency (see annex III) does not include harmonized conflict of laws rules for
adoption by enacting States, thus leaving these matters to established rules and
practices. While insolvency proceedings may typically be governed by the law
of the State in which those proceedings are commenced (the lex fori concur-
sus), many States have adopted exceptions to the application of that law, which
vary both in number and scope. The diversity in the number and scope of such
exceptions may create uncertainty and unpredictability for parties involved in
cross-border insolvency proceedings. By specifically addressing, in a trans-
parent and predictable manner, issues of applicable law an insolvency law can
assist in providing certainty with respect to the effects of insolvency proceed-
ings on the rights and claims of parties affected by those proceedings.


          2.   Law applicable to the validity and effectiveness
                         of rights and claims
81. In a purely domestic setting, insolvency law does not “create” rights
(personal or proprietary) or claims, but should respect the rights and claims
that have been acquired against the debtor according to other applicable laws,
that is civil, commercial or public law. Insolvency law concerns itself with
determining the relative position of each of those rights and claims once insol-
vency proceedings have commenced and, where appropriate, with establishing
the restrictions and modifications to which they will be subject in insolvency
proceedings in order to fulfil the collective aims of those proceedings. These
limits and restrictions are “insolvency effects” because they arise from the
commencement of insolvency proceedings against a debtor.

82. In the context of cross-border insolvency, it is essential to distinguish
between the creation of rights and claims under the law designated as appli-
cable law (whether domestic or foreign substantive law) in accordance with the
conflict of laws rules of the forum and the insolvency effects on those rights
and claims. Since, as noted, the insolvency law does not establish rights or
claims, the issue of whether a given right or claim has been created, and the
content of that right or claim, belongs to the realm of general conflict of laws
rules. It is typical under general conflict of laws rules, for example, that the law
governing the contract will determine if a contractual claim exists against the
insolvent debtor and the amount of that claim; that the lex rei sitae will deter-
mine if a security interest in immovable assets has been created in favour of
a specific creditor, and so on. In this sphere, each State will apply its own
conflict of laws rules, including any international conventions in force. In the
case of an insolvency proceeding, the forum State will usually apply its con-
flict of laws rules to determine which law governs the validity and effective-
ness of a right or claim before considering the treatment of the right or claim
in the insolvency proceedings. It is important to stress that the determination
of validity and effectiveness is not an insolvency question, but a matter of
other applicable law.
Part two: I. Application and commencement                                       69


                   3.    Law applicable in insolvency proceedings:
                                lex fori concursus
83. Once a right or claim is determined to be valid and effective under the law
designated as applicable by the conflict of laws rules of the forum, a second
issue is the effect of insolvency proceedings on the right or claim—that is,
whether it will be recognized and admitted in the insolvency proceedings and,
if so, its relative position. This is an insolvency matter. From the conflict of
laws point of view, the problem in this second phase lies in determining the
law applicable to these insolvency effects. It is quite typical that the law of the
State in which insolvency proceedings are commenced, the lex fori concursus,
will govern the commencement, conduct, administration and conclusion of
those proceedings. This would generally include, for example, determining the
debtors that may be subject to the insolvency law; the parties that may apply
for commencement of insolvency proceedings and the eligibility tests to be
met; the effects of commencement, including the scope of application of a stay;
the organization of the administration of the estate; the powers and functions
of the participants; rules on admissibility of claims; priority and ranking of
claims; and rules on distribution. Accordingly, this law generally will govern
the insolvency effects over rights and claims validly acquired under foreign
law, for example, whether the right or claim, given its nature and conditions,
is admissible in the insolvency of the debtor and how it will be ranked.

84. Problems may arise when the law governing the ranking of a claim and
the applicable law other than the insolvency law governing the claim are
different. The categories of privileges and priorities that exist and the ranking
of claims is always established by the lex fori concursus. Normally, when
establishing these categories and ranking, the insolvency law of a State takes
into account the existence of these claims under the domestic law of the State.
However, the claim of a creditor may be constituted in accordance with a
foreign law. In that case, it is necessary to determine which claims created
under foreign law qualify as equivalent to domestic law claims conferring
certain privileges or priorities. In other words, it is necessary to examine
whether the kind of claim created under foreign law is “equivalent” to the kind
of claim upon which the lex fori concursus confers a special status in insol-
vency proceedings. The test to apply is whether or not both claims, given their
essential content and their function, correspond to each other to the extent that
they can be considered as “functionally interchangeable”. If the answer is in
the affirmative, the claims should be considered equivalent and receive the
same treatment in insolvency proceedings. In the event that equivalence cannot
be established, the claim would generally be treated as an ordinary claim.


              4.        Law applicable in insolvency proceedings:
                         exceptions to the lex fori concursus
85. To determine the insolvency effects on valid and effective rights and
claims, some laws adopt exceptions to the application of the lex fori concursus.
The purpose of the exception is not to change the law applicable to the
70                                        UNCITRAL Legislative Guide on Insolvency Law


question of validity and enforceability (which continues to be governed by the
general conflict of laws rules of the forum), but to change the law applicable
to the insolvency effects. Instead of applying the lex fori concursus, the insol-
vency effects may be governed, for example, by the same law applicable to the
question of validity and effectiveness. For instance, the insolvency effects over
a right to set-off may be determined not by the lex fori concursus, but by the
law applicable to the right to set-off. Other examples of exceptions to the
application of the law of the forum that have been adopted by different insol-
vency laws address the law applicable to payment systems, labour contracts,
avoidance provisions and proprietary rights.

(a)   Payment and settlement systems and regulated financial markets
86. Exceptions to the application of the lex fori concursus respond, in general,
to certain social policy considerations. Some laws focus, for example, on sup-
porting commercial certainty and reducing risk for the parties engaged in
commercial transactions. The parties to a transaction shape their relationships
against the background of a specific legal environment, which includes consi-
deration of the degree to which their rights will be protected in the event of
the insolvency of the debtor, the most typical risk faced by any creditor. The
application of the law under which the right or claim in question was created
may be, in general, less costly for the creditor to learn, more predictable in
terms of insolvency effects and more difficult for the debtor to manipulate ex
post than the application of the law of the debtor’s centre of main interests or
domicile. On that basis, it may be argued that it would be reasonable, under
certain circumstances, to permit and protect reliance by the parties on the law
under which the right or claim was created. A key example relates to payment
or settlement systems and regulated financial markets, which many insolvency
laws recognize as requiring an exception to the application of the lex fori
concursus. By applying the law that is applicable to the system or the regulated
market, alteration of the mechanisms for payment and settlement in the event
of insolvency of a participant can be avoided, thus protecting general certainty
and confidence in the system or market and avoiding systemic risk.

(b)   Labour contracts
87. Some laws adopt exceptions to preserve certain rights or interests specially
protected by the law of a State from the uncertainties or inconsistencies that may
result from the application of the insolvency effects of a foreign lex fori concur-
sus. For example, with respect to labour contracts, special (often mandatory)
protections may be afforded in terms of a financial safety net for workers or
restrictions on the rejection or modification of those contracts in insolvency.
The rationale of such provisions lies in protecting the reasonable expectations of
employees with respect to their contract of employment, recognizing that work-
ers may have a relatively weaker bargaining position than their employer, and in
ensuring non-discrimination among workers working in the same State, whether
they are employed by a local or by a foreign employer. In some States, such
protections will apply only to individual employment contracts, while in others
these provisions also will apply to collective bargaining agreements.
Part two: I. Application and commencement                                      71


(c)   Security interests
88. Some insolvency laws also adopt the approach of providing an exception
to the application of the lex fori concursus with respect to security interests.
This solution means that the law governing a right in rem would determine not
only its creation and general validity, but also its effectiveness in the case of
insolvency proceedings. In other words, the position of the real security
interest in insolvency proceedings commenced abroad will not be established
by the lex fori concursus, but by the insolvency rules of the law applicable to
the security interest. Application of the lex fori concursus otherwise may affect
the legal framework for secured lending, introducing a factor of instability that
may increase the domestic cost of finance. If foreign proceedings intrude upon
local security interests, the value of those security interests may be seriously
impaired. Similarly, a transfer of the debtor’s centre of main interests to a
different State can bring about a radical change in the position of the secured
party. Rights of set-off may also be subject, as noted above, to law other than
the law of the forum, for reasons related to the parties’ expectations, especially
if they engage in regular dealings with each other.


(d)   Avoidance provisions
89. The rationale of supporting certainty and diminishing risk may also apply
to the application of avoidance provisions. Many insolvency laws provide that
the law governing the avoidance of transactions should be the lex fori concur-
sus, even where, under the general conflict of laws rules of the forum, the
transactions to be avoided would be governed by foreign law. Other laws look
to the law governing the transaction to also govern avoidance actions relating
to the transaction. The policy underlying these exceptions to the application of
the lex fori concursus protects the counterparty and its reliance on the law
governing the transaction. Such an approach may provide counterparties with
some degree of certainty and predictability that their transaction with the
debtor will not subsequently be subject to attack in insolvency proceedings and
assist in reducing the cost of credit and commercial transactions because of the
diminished risk of avoidance (which may be essential in the case of trans-
actions taking place in a payment or settlement system).

90. Some of the laws that look to the law governing the transaction for avoid-
ance actions adopt an approach that combines both the lex fori concursus and
the law governing the transaction in one of several ways. One approach pro-
vides that a transaction will not be subject to avoidance in insolvency unless
it is avoidable both under the law of the State in which the insolvency proceed-
ings commenced and the law governing the transaction. A second approach
provides that a transaction can be avoided if avoidance can be achieved under
either the law of the forum or the law governing the transaction. One law, for
example, provides that the law of the forum will apply to avoidance, but
recognizes the application of a different law where that different law is stricter
than the law of the forum and would lead to avoidance of a wider range of
transactions.
72                                            UNCITRAL Legislative Guide on Insolvency Law


     5.   Achieving a balance between the desirability of exceptions
                       and the goals of insolvency
91. It is critical that policy considerations that form the basis of an exception
to the application of the lex fori concursus be weighed against other consi-
derations that are central to insolvency proceedings, in particular the goal of
maximizing the value of the insolvency estate for the benefit of all creditors,
rather than specific individual creditors, and treating all similarly situated
creditors equally. The law of the forum will be designed to support the specific
goals of insolvency in that State and will provide certainty for the insolvency
representative in performing many of its functions with respect to the insol-
vency proceedings, including avoidance of transactions, treatment of contracts,
treatment of claims and so on. Its application in insolvency proceedings may
avoid potentially costly and extensive litigation to determine issues of applica-
ble law for purposes of insolvency effects and the validity and effectiveness of
rights or claims given the insolvency effects under the law of the forum. Thus,
in many circumstances the application of the lex fori concursus for insolvency
effects may reduce costs and delays and therefore maximize the value of the
insolvency estate for the benefit of all creditors. Furthermore, the application
of an exception to the lex fori concursus for insolvency effects may result in
disparate treatment of the insolvency effects on similarly situated creditors
merely because different applicable law governs their rights and claims. It may
be argued, for example, that the rules of set-off of the forum should be applied
to claims on the basis that, in insolvency, rights of set-off are closely related
to the proof and quantification of claims and policies governing the equal
treatment of creditors. Since these are questions regulated by the law of the
forum, the rights of set-off should be similarly regulated.



                               Recommendations 30-34
     Purpose of legislative provisions
          The purpose of provisions on the applicable law in insolvency proceed-
     ings is:
          (a) To facilitate commerce by recognizing, in insolvency proceedings,
     the rights and claims that arise before commencement of insolvency proceed-
     ings and the law that will apply to the validity and effectiveness of those rights
     and claims; and
          (b) To establish the law applicable in insolvency proceedings and excep-
     tions, if any, to the application of that law.

     Contents of legislative provisions
     Law applicable to validity and effectiveness of rights and claims
     (paras. 81 and 82)
          30. The law applicable to the validity and effectiveness of rights and
     claims existing at the time of the commencement of insolvency proceedings
Part two: I. Application and commencement                                             73




    should be determined by the private international law rules of the State in
    which insolvency proceedings are commenced.


    Law applicable in insolvency proceedings: lex fori concursus
    (paras. 83 and 84)
        31. The insolvency law of the State in which insolvency proceedings are
    commenced (lex fori concursus) should apply to all aspects of the commence-
    ment, conduct, administration and conclusion of those insolvency proceedings
    and their effects. These may include, for example:
        (a) Identification of the debtors that may be subject to insolvency
    proceedings;
        (b) Determination of when insolvency proceedings can be commenced
    and the type of proceeding that can be commenced, the party that can apply
    for commencement and whether the commencement criteria should differ
    depending upon the party applying for commencement;
         (c) Constitution and scope of the insolvency estate;
         (d) Protection and preservation of the insolvency estate;
         (e) Use or disposal of assets;
         (f) Proposal, approval, confirmation and implementation of a plan of
    reorganization;
         (g) Avoidance of certain transactions that could be prejudicial to certain
    parties;
         (h) Treatment of contracts;
         (i) Set-off;
         (j) Treatment of secured creditors;
         (k) Rights and obligations of the debtor;
         (l) Duties and functions of the insolvency representative;
         (m) Functions of the creditors and creditor committee;
         (n) Treatment of claims;
         (o) Ranking of claims;
         (p) Costs and expenses relating to the insolvency proceedings;
         (q) Distribution of proceeds;
         (r) Conclusion of the proceedings; and
         (s) Discharge.


    Exceptions to the application of the law of the insolvency proceedings
    (paras. 85-90, specifically paras. 86 and 87)
          32. Notwithstanding recommendation 31, the effects of insolvency pro-
    ceedings on the rights and obligations of the participants in a payment or
    settlement system or in a regulated financial market should be governed solely
    by the law applicable to that system or market.
74                                         UNCITRAL Legislative Guide on Insolvency Law




     Recommendations 30-34 (continued)
         33. Notwithstanding recommendation 31, the effects of insolvency pro-
     ceedings on rejection, continuation and modification of labour contracts may
     be governed by the law applicable to the contract.

          34. Any exceptions additional to recommendations 32 and 33 should be
     limited in number and be clearly set forth or noted in the insolvency law.
        II. Treatment of assets on commencement
                of insolvency proceedings
              A.    Assets constituting the insolvency estate
                                1.   Introduction
1. Fundamental to insolvency proceedings is the need to identify, collect,
preserve and dispose of the debtor’s assets. Many insolvency systems place
these assets under a special regime sometimes referred to as the insolvency
estate, over which the insolvency representative will have specified powers,
subject to certain exceptions.

2. The present Legislative Guide uses the term “estate” in its functional sense
to refer to assets of the debtor that are controlled by the insolvency representa-
tive and are subject to the insolvency proceedings. There are some important
differences in the way in which the concept of the insolvency estate is under-
stood in various jurisdictions. In some States, the insolvency law provides that
legal title over the assets is transferred to the designated official (generally the
insolvency representative). In others, the debtor continues to be the legal owner
of the assets, but its powers to administer and dispose of those assets are
limited. Either the insolvency representative will have complete control of the
assets or the debtor will only be able to deal with assets in the ordinary course
of business and use or disposal of assets outside the ordinary course of busi-
ness, including by the creation of security interests, will require the consent of
the insolvency representative or, in some cases, the court or creditors.

3. Irrespective of the applicable legal tradition, an insolvency law will need
to clearly identify the assets that will be subject to the insolvency proceedings
and therefore included within the concept of the estate as discussed in the
Guide and indicate how they will be affected by those proceedings, including
clarifying the relative powers of the various participants. Identification of
assets and their treatment will determine the scope and conduct of the proceed-
ings and, in particular in reorganization, will have a significant bearing on the
likely success of those proceedings. The inclusion in an insolvency law of clear
and comprehensive provisions on these issues will ensure transparency and
predictability for both creditors and the debtor.

               2.   Assets included in the insolvency estate
(a)   General definition of the insolvency estate
4. The estate may be expected to include all assets of the debtor, including
rights and interests in assets, wherever located, whether in the forum or a

                                         75
76                                                  UNCITRAL Legislative Guide on Insolvency Law


foreign State, whether or not in the possession of the debtor at the time of
commencement, and including all tangible (whether movable or immovable)
and intangible assets. It would include the debtor’s rights and interests in
encumbered assets and in third-party-owned assets (where the continued use of
those assets by the estate may be subject to other provisions of the insolvency
law—see chap. II, paras. 90 and 91). Generally, assets acquired by either the
debtor or the insolvency representative after commencement of the insolvency
proceedings (subject to specific exclusions that would apply in the case of
natural person debtors—see below) and assets recovered through avoidance or
other actions would also be included. Some assets may be freely sold or
exchanged in the course of the proceedings, while others may be subject to
limitations that arise from contract or other law (e.g. a non-assignable govern-
ment licence or a customer list that is subject to privacy restrictions) or involve
mediating problems that can arise with respect to other rights in those assets.
Notwithstanding such limitations, it is desirable that these assets be included
in the estate.

5. Tangible assets should be readily found on the debtor’s balance sheets,
such as cash, equipment, inventory, works in progress, bank accounts,
accounts receivable and real estate. The assets to be included within the cate-
gory of intangible assets may be defined differently in different States, depend-
ing upon national law, but may include intellectual property, securities and
financial instruments, insurance policies, contract rights (including those relat-
ing to assets owned by third parties) and rights of action arising from a tort.1
The inclusion of some intangible assets in the estate may give rise to conflicts
with other laws, such as those restricting transferability or laws relating to
privacy protection. In the case of natural persons, the estate may also include
assets such as inheritance rights in which the debtor has an interest or to which
the debtor is entitled at the commencement of insolvency proceedings or which
come into existence during the proceedings, as well as the debtor’s interest in
assets owned jointly with another person, including the debtor’s spouse.

6. Notwithstanding the desirability of a broad definition of the estate, the
inclusion of a number of types of asset can be controversial. Some assets can
be included in the estate without difficulty, such as assets belonging to the
debtor and that are unencumbered, assets that are not disputed by a third party
and assets recovered by the insolvency representative, whether through claims
against a third party or through avoidance actions. Other assets can be ex-
cluded from the estate without difficulty, such as assets belonging to a third
party in which the debtor has no interest and assets belonging, with full own-
ership rights, to the debtor’s spouse. Assets such as encumbered assets, joint
assets, assets located abroad, some intangible assets and third-party-owned
assets in which the debtor has an interest could raise difficult questions. These
are discussed in the following sections.

      1
        Where the debtor is a natural person, some jurisdictions exclude torts of a personal nature such
as defamation, injury to credit or reputation or personal bodily injury, where the debtor remains
personally entitled to sue and to retain what is recovered on the basis that the incentive to vindicate
wrongdoing otherwise would be diminished, but may not be entitled to sue for any loss of earnings
associated with those causes of action.
Part two:   II. Treatment of assets on commencement of insolvency proceedings   77


(b)   Encumbered assets
7. One question of some importance is whether the insolvency law includes
encumbered assets as part of the insolvency estate. Insolvency laws adopt
different approaches to the treatment of such assets. Many laws provide that
encumbered assets are included in the insolvency estate, with the commence-
ment of proceedings giving rise to different effects, such as limiting the
enforcement of security interests by application of a stay. Including encum-
bered assets in the estate and thus limiting the exercise of rights by secured
creditors on commencement of proceedings may assist not only in ensuring
equal treatment of creditors, but may be crucial to the proceedings where the
encumbered asset is essential to the business. For example, where manufactur-
ing equipment or a leased factory building is central to the debtor’s business
operations, reorganization or sale of the business as a going concern cannot
take place unless the equipment and the lease can be retained for the proceed-
ings. There will be advantages, in particular in reorganization and where the
business is to be sold as a going concern in liquidation, in having all assets of
the debtor available to the insolvency estate from the time of commencement.

8. Where encumbered assets are included in the insolvency estate, a number
of insolvency laws provide certain protections, such as those relating to main-
taining the value of the encumbered asset or the secured portion of a creditor’s
claim and to specified situations where the encumbered asset may be separated
from the estate. An insolvency law should make it clear that such an inclusion
will not deprive secured creditors of their rights in the encumbered assets, even
if it does operate to limit the exercise of those rights (e.g. postponement by
operation of the stay) and should specifically ensure the protection of the rights
of secured creditors in encumbered assets.

9. Other insolvency laws provide that encumbered assets are unaffected by
insolvency proceedings and secured creditors may proceed to enforce their
legal and contractual rights. Recognizing that there will be cases where encum-
bered assets may be crucial to the proceedings, there are examples of laws that
provide that even where those assets are unaffected by the insolvency, the
court may be requested to prevent such enforcement where the asset is neces-
sary for the business to continue operating. Exclusion of encumbered assets
may have the advantage of generally enhancing the availability of credit be-
cause secured creditors would be reassured that their rights would not be
adversely affected by the commencement of insolvency proceedings. It is in-
creasingly accepted, however, that this general advantage to an economy is
outweighed by the advantages to be derived from including encumbered assets
in the insolvency estate and restricting the exercise of secured creditors’ rights
as noted above.

(c)   Third-party-owned assets
10. Some jurisdictions permit assets in which a creditor retains legal title or
ownership (e.g. a retention of title or a lease arrangement) to be separated from
the insolvency estate on the basis that the insolvency law should respect the
78                                       UNCITRAL Legislative Guide on Insolvency Law


creditor’s legal title in the asset. In some jurisdictions the separation of the
asset may be subject to the provisions of the insolvency law relating to treat-
ment of contracts. The estate will generally include, however, as indicated
above in the general definition of the estate, any rights that the debtor might
have in respect of those third-party-owned assets. There will be cases where
the third-party-owned assets may be crucial, like encumbered assets, to the
continued operation of the business, whether in reorganization or sale as a
going concern in liquidation. In those cases, it will be advantageous for the
insolvency law to include a mechanism that will permit third-party-owned
assets to remain at the disposal of the insolvency proceedings, subject to pro-
tecting the interests of the third-party owner and to the right of the third party
to dispute that treatment.

11. If the economic terms of the transaction demonstrate that it is a device to
finance the acquisition of an asset, although structured, for example, as a lease,
some laws treat the arrangement as a secured lending arrangement and the
lessor will be subjected to the same treatment in insolvency as other secured
creditors. A transaction will be a financing device where, at the end of the term
of the lease, either the debtor can retain the asset for the payment of a nominal
sum or the remaining value of the asset is negligible. The insolvency law may
regard the debtor’s rights as part of the insolvency estate and permit the asset
to be used by the insolvency representative subject to certain conditions as
described below (paras. 90 and 91).

12. Where the interest in assets that is claimed by the debtor is disputed by
a third party, it will be desirable for the insolvency law to enable those assets
to be protected on an interim basis to ensure their preservation, pending deci-
sion by the court as to ownership. Where the decision is ultimately made that
the assets do not form part of the estate, the law may also address issues of
damage to the third party arising from the debtor’s retention. The issue of
damages may also be relevant where a third party withholds assets that are
found to form part of the estate.

(d)   Foreign assets
13. Whether the debtor’s assets outside the country where the proceedings are
taking place will become part of the estate raises issues of cross-border insol-
vency. This may be of particular importance in reorganization, where the ex-
clusion of foreign assets could significantly affect the success of the proceed-
ings. Some insolvency laws take the approach that there should be a single
insolvency proceeding, based in the country where the debtor has its head
office or place of registration or incorporation (centre of main interests), that
will apply to the debtor’s assets wherever situated (the universal approach).
This approach includes the idea that the State adopting it will accept the same
claim made under the insolvency law of another State. Other insolvency laws
are based upon an approach that limits the applicability of the insolvency law
to the geographical area governed by the State enacting the legislation (the
territorial approach). This approach requires different proceedings to be com-
menced in each State in which the debtor has assets or in which different
Part two:      II. Treatment of assets on commencement of insolvency proceedings                 79


branches or establishments of the debtor are located. Another approach is a
modified version where a State claims universal application of its own law, but
does not recognize the same universal application of the laws of other States.

14. The existing diversity of approaches to this issue creates considerable
uncertainty and undermines the effective application of national insolvency
laws. However, as the differences between insolvency laws increasingly
narrow and greater convergence emerges, there are fewer reasons for maintain-
ing the territorial approach. It is increasingly desirable that an insolvency law
provide that the insolvency estate comprise all assets of the debtor wherever
located.2 However, since divergence is likely to remain for some time, the
UNCITRAL Model Law on Cross-Border Insolvency establishes a regime for
effective cooperation in cross-border insolvency cases through recognition of
foreign decisions and access for foreign insolvency representatives to local
court proceedings. The regime is intended to be compatible with all legal
systems and is discussed in more detail in the documents included in annex III.

(e)         Recovered assets
      (i)    Avoidance proceedings
15. The insolvency estate generally will include any assets or their value
recovered through avoidance proceedings where the transaction involving
the assets was of the type subject to avoidance under an insolvency law.
Such transactions may include transactions that resulted in preferential treat-
ment to some creditors, were prejudicial to the insolvency estate or were
entered into in an effort to defeat the collective rights of creditors (see below,
paras. 170-184).

      (ii) Unauthorized post-application and post-commencement transactions
16. Many insolvency laws adopt measures intended to limit the extent to
which a debtor subject to insolvency proceedings can deal with its assets,
whether encumbered or not, without the authorization of the court or the
insolvency representative (see below, paras. 70-73). These restrictions will
generally apply after the commencement of insolvency proceedings, but may
also apply after an application for commencement of proceedings in those
cases where the powers to deal with assets of the estate are given to an interim
insolvency representative. Some insolvency laws treat transactions that are not
authorized as invalid and unenforceable as against the insolvency estate and
enable any assets transferred to be reclaimed, except in some cases where the
counterparty gave value or can prove that the transaction did not impair credi-
tors’ rights. Other insolvency laws achieve the same result by addressing
unauthorized contracts in terms of avoidance provisions, depending upon how
the suspect period is calculated (see below, para. 188).

       2
         See for example, EC Regulation 1346/2000, which relies on the principle of proceedings with
universal scope, while retaining the possibility of opening secondary proceedings whose effects are
limited to the territory of the member State concerned. There is automatic recognition of foreign
decisions and special rules for coordination between liquidators.
80                                              UNCITRAL Legislative Guide on Insolvency Law


                 3.   Assets excluded from the insolvency estate
(a)       General exclusions
17. The insolvency law may exclude certain assets from the estate. Insolvency
laws adopt different approaches to this issue. Assets excluded from the estate
may include, for example, certain assets owned by a third party that are in the
possession of the debtor when the proceedings commence, such as trust assets
and assets subject to an arrangement (whether contractual or otherwise) that
does not involve a transfer of title, but rather use of the assets and return to
the owner once the purpose for which they were in the possession of the debtor
has been fulfilled.3 They may also include assets subject, under some laws, to
reclamation, such as goods supplied to the debtor before commencement, but
not paid for and recoverable by the supplier (subject to identification and other
applicable conditions).


(b)       Where the debtor is a natural person
18. In the case of insolvency of a natural person, the insolvency law may
exclude certain assets from the estate, such as post-application earnings from
the provision of personal services by the debtor or monies received for public
works by the debtor, assets that are necessary for the debtor to earn a living
and personal and household assets, such as furniture, household equipment,
bedding, clothing and other assets necessary to satisfy the basic domestic needs
of the debtor and his or her family. Some jurisdictions also exclude torts of a
personal nature such as defamation, injury to credit or reputation or personal
bodily injury. The debtor remains personally entitled to sue and to retain what
is recovered in such actions on the basis that the incentive to vindicate wrong-
doing otherwise would be diminished, but the debtor may not be entitled to sue
for any loss of earnings associated with those causes of action. Such exclusions
generally would not be available to legal person debtors.

19. Where an insolvency law excludes certain assets from the estate of a
natural person, those assets should be clearly identified and the number and
value of the exclusions limited to the minimum necessary to preserve the
personal rights of the debtor and allow the debtor to lead a productive life. In
identifying such exclusions, consideration might need to be given to applicable
human rights obligations, including international treaty obligations, which are
intended to protect the debtor and relevant family members and may affect the
exclusions that should be made.4 A further consideration may be the economic
effects of exclusions; some research suggests that the full or substantial exemp-
tion of personal assets from insolvency proceedings may have a positive effect
on entrepreneurship and risk-taking.



      3
      Such an arrangement may be known as a bailment or depositum.
      4
      In Europe, for example, the Convention for the Protection of Human Rights and Fundamental
Freedoms of 1950 is relevant.
Part two:   II. Treatment of assets on commencement of insolvency proceedings                         81


   Joint assets
20. Different approaches are adopted to the treatment of personal assets
owned jointly by a natural person debtor and his or her spouse. That treatment
may be specified by the insolvency law or law other than the insolvency law,
such as that relating to matrimonial property or property ownership and, in
some federal jurisdictions, may involve questions of both state and federal law.
The relationship between those other laws and the insolvency law may deter-
mine how certain provisions of the insolvency law, for example avoidance
provisions, will apply.

21. One approach to the treatment of joint assets is to exclude them com-
pletely from the estate. Another approach provides that, where the proceedings
are opened against the assets of one spouse, the part of the mutual assets
belonging to that spouse can become part of the insolvency estate if, under law
other than the insolvency law, the assets can be divided for purposes of execu-
tion (where division of the assets will be conducted outside of the insolvency
law and proceedings). The choice between these approaches may therefore
depend upon the operation of law other than the insolvency law and factors
such as the ease with which the assets may be divided (see below, para. 87).

                4.    Time of constitution of the insolvency estate
                              and collection of assets
22. To provide certainty for the debtor and for creditors, the insolvency law
should specify the date by reference to which the estate will be constituted.
Some insolvency laws refer to the effective date of commencement of proceed-
ings, while others refer to the date of the application for commencement or to
an act of insolvency that forms the basis of the application. The significance
of the difference between the dates relates to the treatment (and most impor-
tantly the protection) of the debtor’s assets in the interim period between
application and commencement. For that reason, some laws constitute the
estate from the date of application. Other laws, for reasons of clarity and
certainty, constitute the estate from the date of commencement, but also
contain provisions that restrict the debtor’s powers to dispose of property
during the period after the application is made. The insolvency representative
can reclaim assets disposed of in that period. A further consideration with
respect to protection of assets between application and commencement is the
relevance of avoidance provisions and the date from which the suspect period
is calculated (see below, para. 188).

23. Whichever date is chosen for constitution of the estate, the estate may be
expected to include assets of the debtor as at that date as well as assets
acquired by the insolvency representative and the debtor after that date,
whether in the exercise of avoidance powers or in the normal course of
operating the debtor’s business.5
      5
        Except for those assets excluded from the estate in the case of natural person debtors (discussed
above, paras. 18-21).
82                                                 UNCITRAL Legislative Guide on Insolvency Law


24. Once the assets to be included in the estate are identified, they must be
collected. To achieve this, the insolvency law may include powers enabling the
insolvency representative to establish control over assets determined to be part
of the estate, as well as obligations to ensure that the debtor and other relevant
parties assist and cooperate with the insolvency representative in that regard.
Where assets are located in a foreign country, additional measures will be
required, such as those set forth in the UNCITRAL Model Law on Cross-
Border Insolvency (see annex III).



                                  Recommendations 35-38

     Purpose of legislative provisions
           The purpose of provisions relating to the insolvency estate is:
          (a) To identify those assets which will be included in the estate,
     including the debtor’s interests in encumbered assets and in third-party-owned
     assets; and
           (b) To identify the assets, if any, that will be excluded from the estate.

     Contents of legislative provisions
     Assets constituting the insolvency estate (paras. 1-16)
           35. The insolvency law should specify that the estate should include:
          (a) Assets of the debtor,6 including the debtor’s interest in encumbered
     assets and in third-party-owned assets;
           (b) Assets acquired after commencement of the insolvency proceedings;
     and
           (c) Assets recovered through avoidance and other actions.

          36. In the case of insolvency proceedings commenced where the debtor
     has its centre of main interests, the insolvency law should specify that the
     estate should include all assets of the debtor wherever located.7

     Time of constitution of the insolvency estate (paras. 22-24)
          37. The insolvency law should specify the date from which the estate is
     to be constituted, being either the date of application for commencement or the
     effective date of commencement of insolvency proceedings.




       6
         Ownership of assets would be determined by reference to the relevant applicable law, where
the term “assets” is defined broadly to include property, rights and interest of the debtor, including
the debtor’s rights and interests in third-party-owned assets.
       7
         Where the insolvency law adopts a universal approach, as recommended here, the law should
also address the issue of recognition of foreign proceedings, see the UNCITRAL Model Law on Cross-
Border Insolvency (annex III).
Part two:    II. Treatment of assets on commencement of insolvency proceedings                     83




     Assets excluded from the insolvency estate where the debtor is
     a natural person8 (paras. 18-21)
         38. The insolvency law should specify the assets, if any, that are
     excluded from the estate where the debtor is a natural person.




         B. Protection and preservation of the insolvency estate
                                       1.    Introduction
25. Essential objectives of an effective insolvency law are protecting the
value of the insolvency estate against diminution by the actions of the various
parties to insolvency proceedings and facilitating administration of those pro-
ceedings in a fair and orderly manner. The parties from whom the estate needs
the greatest protection are the debtor and its creditors.

              2. Protection of the estate by application of a stay
26. With regard to creditors, one of the fundamental principles of insolvency
law is that insolvency proceedings are collective proceedings, which require
the interests of all creditors to be protected against individual action by one of
them. Many insolvency laws include a mechanism to protect the value of the
insolvency estate that not only prevents creditors from commencing actions to
enforce their rights through legal remedies during some or all of the period of
the liquidation or reorganization proceedings, but also suspends actions already
under way against the debtor. Such a mechanism is variously termed a
“moratorium”, “suspension” or “stay”, depending on the effect of the mecha-
nism. For the purposes of the Legislative Guide, the term “stay” is used in a
broad sense to refer to both suspension of existing actions and a moratorium
on the commencement of new actions.

   (i)      Liquidation
27. As a general principle, the emphasis in liquidation is on realizing the
assets, in whole or in part, so that creditors’ claims can be satisfied from
the proceeds of the estate as quickly as possible. Maximizing value is an
overriding objective. The imposition of a stay can ensure a fair and orderly
administration of the liquidation proceedings, providing the insolvency repre-
sentative with adequate time to avoid making forced sales that fail to maximize
the value of the assets being liquidated and also an opportunity to see if the
business can be sold as a going concern, where the collective value of assets

      8
        Exclusions are generally not provided for legal person debtors. On the types of asset that may
be excluded in respect of natural persons, see above, paras. 18-21.
84                                        UNCITRAL Legislative Guide on Insolvency Law


may be greater than if the assets were to be sold piecemeal. A stay also allows
the insolvency representative to take stock of the debtor’s situation, including
actions already pending, and provides time for all actions to be fully consi-
dered, increasing the possibility of achieving a result that is not prejudicial to
the interests of the debtor and creditors. The balance that is difficult to achieve
in liquidation proceedings is between the competing interests of secured credi-
tors, who will often hold a security interest in some of the most important
assets of the business and wish to enforce that security interest, and unsecured
creditors, who may benefit from retention of that asset to facilitate sale of the
business as a going concern.

     (ii) Reorganization
28. In reorganization proceedings, the application of a stay facilitates the
continued operation of the business and allows the debtor a breathing space to
organize its affairs, time for preparation and approval of a reorganization plan
and for other steps such as shedding unprofitable activities and onerous
contracts, where appropriate. As in liquidation, it also provides an opportunity
to consider actions pending against the debtor. Given the goals of reorgani-
zation, the impact of the stay is greater and therefore more crucial than in
liquidation and can provide an important incentive to encourage debtors to
initiate reorganization proceedings. At the same time, the commencement of
proceedings and the imposition of the stay give notice to all those who do
business with the debtor that the future of the business is uncertain. This can
cause a crisis of confidence and uncertainty as to how the insolvency proceed-
ings will affect suppliers, customers and employees of the debtor’s business.

29. The immediate benefits that accrue to the debtor by having a broad stay
quickly imposed to limit the actions of creditors will need to be balanced
against the longer-term benefits that are derived from limiting the degree to
which the stay interferes with contractual relations between debtors and credi-
tors, especially secured creditors.

                    3.     Scope of application of the stay
(a)    Actions to which the stay will apply
30. Some States adopt the approach that, in order to ensure the effectiveness
of the stay, it must be very wide, applying to all remedies and proceedings
against the debtor and its assets, whether administrative, judicial or self-help,
and restraining the debtor from taking certain actions with respect to its assets,
unsecured and secured creditors from enforcing their rights, as well as Govern-
ments from exercising priority rights.

31. Examples of the types of action and act that may be stayed could include
the commencement or continuation of actions or proceedings against the
debtor or in relation to its assets; the commencement or continuation of
enforcement proceedings in relation to assets of the debtor, including the exe-
cution of a judgement and actions to make security interests effective against
Part two:   II. Treatment of assets on commencement of insolvency proceedings                       85


third parties or to enforce a security interest; recovery by any owner or lessor
of property that is used or occupied by, or is in the possession of, the debtor;
payment or provision of a security interest in respect of a debt incurred by the
debtor prior to the commencement date; the transfer, encumbrance or other
disposal of any assets by the debtor (in reorganization, this might be limited
to transfer, encumbrance or disposal outside the ordinary course of business);
the termination of a contract with the debtor by the counterparty9 (except
where the contract provides a termination date that happens to fall after com-
mencement); and termination, suspension or interruption of supplies of essen-
tial services (e.g. water, gas, electricity and telephone) to the debtor. Article 20
of the UNCITRAL Model Law on Cross-Border Insolvency is an example of
a stay provision, which provides that commencement or continuation of
individual actions or individual proceedings concerning the debtor’s assets,
rights, obligations or liabilities and execution against the debtor’s assets are
stayed. The types of individual action referred to above should cover those
commenced both in the courts and before an arbitral tribunal.10

32. With respect to actions to make a security interest effective against third
parties, some laws dealing with security interests provide specified time
periods within which those security interests should be made effective against
third parties, whether by registration, publicity or some other means. Where the
law of a State includes such periods, the insolvency law may recognize them,
permitting security interests to be made effective against the debtor and third
parties after commencement of insolvency proceedings, but within the speci-
fied time period. Where the law does not include such time periods, the stay
applicable on commencement of insolvency proceedings would operate to
prevent the security interest from being made effective. The question of
whether such an act in insolvency would make the security interest effective
against third parties should be distinguished from the question of whether or
not such acts should be permitted. The effect in insolvency will depend upon
the act that is required to make the interest effective. Where, for example,
effectiveness requires registration, it might be permitted to occur after com-
mencement, but where it involves, for example, the secured creditor taking
possession of an asset, a different view might be taken, as such an action
would reduce the assets available for the estate.

33. One of the reasons for including continuation of proceedings within
the scope of the stay is that the need for the insolvency representative to
become involved in ongoing cases (where the debtor is divested of control) can
distract and divert resources away from its task of administering the estate. In
the absence of a stay, a default judgement, for example, could be entered
against the debtor and form the basis of a creditor’s claim in the proceedings
without the insolvency representative being aware of the action. On a proper

       9
         Application of the stay would give the insolvency representative time to assess the contract’s
importance to the proceedings and the action to be taken, that is, continuation or rejection.
       10
         It may not always be possible, however, to implement an automatic stay of arbitral proceed-
ings, such as where the arbitration takes place in a foreign State rather than in the State in which
insolvency proceedings are commenced.
86                                                 UNCITRAL Legislative Guide on Insolvency Law


adjudication of the issues by the court, the insolvency representative would
have the opportunity to defend the action, which might be dismissed or judge-
ment be entered for a smaller amount. Since most insolvency laws include a
mechanism to process claims—addressing submission, verification and admis-
sion—and to make distributions, proceedings with respect to those claims
conducted outside the insolvency case are rendered superfluous. Nevertheless,
some insolvency laws provide that, where legal proceedings against the debtor
(including both commencement and continuation of those proceedings) are
within the scope of the stay, those proceedings can be commenced or con-
tinued at the discretion of the court if it is considered necessary to preserve a
claim or establish the quantum of a claim.11 The same result can be achieved
by providing that the stay of proceedings halts the running of any applicable
limitation period, so that the creditor’s right to bring a claim against the debtor
will be the same on the day the stay is lifted as it was on the day the stay
became effective.

34. Other insolvency laws allow the commencement or continuation of legal
proceedings (without leave of the court), but the application of the stay pre-
vents enforcement of any resulting order. Some insolvency laws limit the
actions that may be pursued and only specific actions, such as employee
actions against the debtor, can be commenced or continued, but any enforce-
ment action resulting from those proceedings will be stayed. In some insol-
vency laws a distinction is made between regulatory and pecuniary actions.
Some laws allow claims of both a regulatory and pecuniary nature to be con-
tinued, others only regulatory claims, such as those which are not designed to
collect money for the estate but to protect vital and urgent public interests,
restraining activities causing environmental damage or activities that are detri-
mental to public health and safety. As a procedural matter, some insolvency
laws limit the initial scope of acts and actions to which the stay applies on
commencement, but provide that upon application, the court might extend the
stay to other types of action and act.

(b)    Exceptions to application of the stay
35. To ensure transparency and predictability, it is highly desirable that an
insolvency law clearly identify the actions that are to be included within and
specifically excepted from the scope of the stay, irrespective of who may
commence those actions, whether unsecured creditors (including priority credi-
tors such as employees, legislative lien holders or Governments), third parties
(such as a lessor or owner of property in the possession or use of the debtor
or occupied by the debtor), secured creditors or others. Exceptions might in-
clude set-off rights and netting of financial contracts (see below, paras. 204-
215); actions to protect public policy interests, such as to restrain environmen-
tal damage or activities detrimental to public health and safety; actions to

      11
         Article 20, paragraph 3, of the UNCITRAL Model Law on Cross-Border Insolvency, for
example, provides that the application of the stay to commencement or continuation of individual
actions or proceedings against the debtor is not to affect the right to commence individual actions or
proceedings to the extent necessary to preserve a claim against the debtor (see annex III).
Part two:      II. Treatment of assets on commencement of insolvency proceedings                   87


prevent abuse, such as the use of insolvency proceedings as a shield for illegal
activities; actions commenced in order to preserve a claim against the debtor;
and actions against the debtor for personal injury or family law claims.12 With
respect to claims against the debtor that have the potential for very large
compensation awards, such as mass tort claims, it is desirable that they be
included within the scope of the stay.

(c)         Secured creditors
36. The scope of rights that are affected by the stay varies considerably
between insolvency laws. There is little debate regarding the need for the stay
to apply to suspend or prevent the commencement of actions by unsecured
creditors against the debtor or its assets. The application of the stay to actions
by secured creditors, however, is potentially more difficult and requires a
number of competing interests to be balanced. These include, for example,
respecting the pre-insolvency priorities of secured creditors as regards their
rights over the encumbered assets; minimizing the effect of the stay on the
value of encumbered assets; and, in cases of reorganization, ensuring that all
assets necessary for the successful reorganization of a viable debtor are
available to the proceedings.

37. Creditors generally seek a security interest for the purpose of protecting
their interests in the event that the debtor fails to repay. If a security interest
is to achieve that objective, it can be argued that, upon commencement of
insolvency proceedings, the secured creditor should not be delayed or pre-
vented from immediately enforcing its rights against the encumbered asset.
The secured creditor has, after all, bargained for a security interest in exchange
for value that reflects the reliance on the security interest. For that reason, the
introduction of any measure that will diminish the certainty of the secured
creditor’s ability to recover debt or erode the value of security interests, such
as applying the stay to postpone enforcement, may need to be carefully con-
sidered. Such a measure may ultimately undermine not only the autonomy of
the parties in their commercial dealings and the importance of observing
commercial bargains, but also the availability of affordable credit; as the pro-
tection provided by security interests declines, the price of credit may need to
increase to offset the greater risk. Some of the insolvency laws that except
actions by secured creditors from the stay focus, as an alternative to the stay,
on encouraging pre-commencement negotiations between the debtor and
creditors to achieve agreement on how to proceed.

      (i)     Reorganization
38. A growing number of insolvency laws accept, however, that in many
cases permitting secured creditors to freely enforce their rights against the
encumbered asset can frustrate the basic objectives of the insolvency

      12
        Some jurisdictions, for example, will exclude from the application of the stay the performance
of obligations of the debtor that do not affect the estate, for example, to give parental access in a
family law situation.
88                                        UNCITRAL Legislative Guide on Insolvency Law


proceedings, in particular in reorganization. For that reason, actions by secured
creditors are increasingly included within the scope of the stay, subject to
certain protections. It may be worth noting that the increasing acceptance by
banks and other financial institutions of moratoriums in voluntary restructuring
negotiations conducted pursuant to, for example, the “London approach” (see
part one, chap. II, para. 17) may be responsible, in part, for the growing
acceptance by secured creditors of the application of the stay to them in
insolvency proceedings.

     (ii) Liquidation
39. Insolvency laws take different approaches to the application of the stay to
actions by secured creditors in liquidation proceedings. As a general principle,
where the insolvency representative’s function is to collect and realize assets
and distribute proceeds among creditors by way of dividend, the secured credi-
tor may be permitted to freely enforce its rights against the encumbered asset
to satisfy its claim without affecting the liquidation of other assets. Some
insolvency laws thus except secured creditors from the scope of the stay.
Where that approach is adopted, however, some flexibility may be needed in
cases where the insolvency representative may be able to achieve a better
result that maximizes the value of the assets for the collective benefit of all
creditors if the stay is applied to secured creditors. This may be particularly
relevant where the business can be sold as a going concern in the context of
the liquidation proceeding. It may also be true in some cases where even
though assets are to be sold in a piecemeal manner, some time is needed to
arrange a sale that will give the highest return for the benefit of all unsecured
creditors.

40. Where actions by secured creditors are included within the scope of the
stay in both liquidation and reorganization proceedings, an insolvency law can
adopt measures that will ensure that the interests of the secured creditor are not
diminished by the stay. These measures may relate to the duration of the stay,
protection of the value of the encumbered assets, payment of interest and
provision of relief from the stay where the encumbered assets are not suffi-
ciently protected or where they are not necessary to the sale of the entire
business or a productive part of it.

          4.   Discretionary or automatic application of the stay
41. A preliminary question on application of the stay is whether it should
apply automatically (by operation of the insolvency law) or at the discretion of
the court. Local policy concerns and factors, such as the availability of reliable
financial information and the ability of the debtor and creditors to access an
independent judiciary with insolvency experience, may affect the decision on
this issue. Application of the stay on a discretionary basis may allow the stay
to be tailored to the needs of the specific case (as regards the debtor, its assets
and its creditors and the time of application and duration of the stay) and avoid
both unnecessary applications of the stay and unnecessary interference with the
rights of secured creditors. This approach, however, has the potential to cause
Part two:   II. Treatment of assets on commencement of insolvency proceedings   89


delay while the court considers the relevant issues; does not create a predict-
able situation for those creditors and third parties to whom the stay ultimately
may apply; and may create a need for some mechanism, such as provisional
measures, to address the period before the court decides on the application of
the stay, as well as requiring notice to be given as to application of the stay.

42. An alternative approach that minimizes delay, helps to maximize the
value of the assets and ensures that the insolvency proceedings are fair and
ordered as well as transparent and predictable might be to provide for the stay
to apply automatically to specified actions (either on application or commence-
ment of proceedings), with the possibility of extension of the stay to other
action at the discretion of the court. This approach is adopted in the
UNCITRAL Model Law on Cross-Border Insolvency: article 20 specifies the
types of action that will be stayed automatically upon recognition of foreign
main proceedings, while article 21 indicates examples of additional relief that
may be ordered upon recognition, at the discretion of the court. The automatic
stay is a feature of many modern insolvency law regimes and can be combined
with provisions permitting relief from the application of the stay in specified
circumstances (see below, paras, 60-62).

                        5.    Time of application of the stay
43. A further concern related to application of the stay is the time at which
it will apply in both liquidation and reorganization proceedings. There are
essentially two approaches. Under the first, the stay applies from the time an
application for commencement of proceedings is made and under the second
from the time of the commencement of proceedings, with provisional measures
being available to cover the period between application and commencement.

(a)   Specifying the exact time of effect of the stay
44. As a preliminary issue, regardless of whether an automatic stay is to be
applicable by reference to the time of application or commencement, it is
important that an insolvency law address the question of the exact time at
which the stay will become effective to ensure protection of the estate, espe-
cially in relation to payments. Different approaches are taken to this issue. In
some laws, the stay becomes effective as of the time of the court’s decision to
commence proceedings, in others when the decision to commence becomes
publicly available. In yet other laws, the stay has effect retroactively from the
first hour of the day the commencement order is made. A similar diversity of
approaches is taken where the stay takes effect when an application for com-
mencement of proceedings is made. Whichever approach is adopted, an insol-
vency law should contain a clear rule.

(b)   Application of the stay from the time an application
      for commencement is made
45. With respect to the point in the proceedings at which the stay should take
effect, one approach applies the stay from the time an application for either
90                                          UNCITRAL Legislative Guide on Insolvency Law


liquidation or reorganization proceedings is made, irrespective of whether it is
a debtor or creditor application. This approach may avoid the need to consider
the availability of interim or provisional measures of protection to cover the
period between the making of the application and the commencement of
proceedings, but will require the application of the stay at a time when a
number of factual matters are not necessarily clear, in particular whether the
debtor will satisfy the commencement criteria. To balance against the risk of
abuse in such a situation, it is desirable, if this approach is followed, that clear
procedures for seeking relief from the stay on an expedited basis be included
in the insolvency law.

(c)         Application from commencement
46. The most common approach to application of the stay is for it to apply
on commencement of the proceedings, when issues of eligibility, jurisdiction
and satisfaction of the commencement criteria will have been resolved and it
is clear that proceedings should be commenced rather than the application be
denied. To address the period between application and commencement, some
insolvency laws permit provisional measures to be ordered. While other pro-
visions of insolvency law also may be relevant to protecting the insolvency
estate before commencement, such as reclamation of assets, these generally
will apply only after the event.

      (i)     Provisional measures
47. In some insolvency laws that do not provide for the proceedings to com-
mence automatically when an application is made, the application of the stay
on commencement is complemented by provisional measures that may be
ordered between application and commencement to protect both the assets of
the debtor that potentially will constitute the insolvency estate and the collec-
tive interests of creditors. Even where the commencement decision is made
quickly, there is the potential in that period for the debtor’s business situation
to change and for dissipation of the debtor’s assets—the debtor may be
tempted to transfer assets out of the business and creditors, on learning of the
application, may take remedial action against the debtor to pre-empt the effect
of any stay that may be imposed upon commencement of the proceedings. The
unavailability of provisional measures in such circumstances could frustrate
the objectives of the insolvency proceedings. As with most provisional
measures, the need for relief generally must be urgent and must outweigh any
potential harm resulting from such measures.

48. Where an insolvency law permits provisional measures to be granted, it
is important that it also include provision for periodic review and, if necessary,
renewal of those measures by the court and that it address what happens to
those measures on commencement of the insolvency proceedings. In many
instances there will be no need for provisional measures to continue to apply
after the commencement of proceedings, as they will be superseded by the
measures applicable on commencement. If, however, provisional relief of a
particular kind is not provided by the measures applicable on commencement
Part two:   II. Treatment of assets on commencement of insolvency proceedings   91


and that type of relief is still required after commencement, the court may
extend the application of that provisional measure in appropriate circum-
stances. Provisional measures would also terminate when an application for
commencement is denied or the order for provisional measures is successfully
challenged.

   (ii) Types of provisional measure
49. Provisional measures may be available on the application of the debtor,
creditors or third parties or be ordered by the court on its own motion. They
may include appointing an interim insolvency representative or other person
(not including the debtor) to administer or supervise the debtor’s business and
to protect assets and the interests of creditors; prohibiting the debtor from
disposing of assets; taking control of some or all of the debtor’s assets; sus-
pending enforcement by creditors of security rights against the debtor; staying
any action by creditors against the debtor’s assets, such as by a secured credi-
tor or retention of title holder; and preventing the commencement or continu-
ation of individual actions by creditors to enforce their claims.

50. Where an insolvency representative is appointed as a provisional measure,
it may not have powers as broad as those of an insolvency representative
appointed on commencement of proceedings and its functions may be limited
to protecting assets and the interests of creditors. It may be given, for example,
the power to use and dispose of the debtor’s assets in the ordinary course of
business and to realize assets in whole or in part in order to protect and
preserve the value of those assets which, by their nature or because of other
circumstances, are perishable, susceptible to devaluation or otherwise in
jeopardy. In any event, it may be necessary to determine the balance of respon-
sibilities between the interim insolvency representative and the debtor with
respect to the operation of the debtor’s business, bearing in mind that no
determination as to commencement of insolvency proceedings has been made.
Since significant harm to the debtor’s business or to the rights of creditors may
result in situations where the court ultimately decides to deny the application
for commencement, it is desirable that the court only exercise the power to
grant provisional measures if it is satisfied that the assets of the debtor are at
risk. In general, the debtor would continue to operate its business and to use
and dispose of assets in the ordinary course of business, except to the extent
restricted by the court.

   (iii) Evidentiary requirements
51. Since these measures are provisional in nature and are granted before the
court’s determination that the commencement criteria have been met, the law
may require the court to be satisfied that there is some likelihood that the
debtor will satisfy the commencement requirements. Where a party other than
the debtor applies for the measure, the applicant may be required by the court
to provide evidence that the measure is necessary to preserve the value or
avoid dissipation of the debtor’s assets. In that case, some form of security for
92                                             UNCITRAL Legislative Guide on Insolvency Law


costs, fees or damages, such as the posting of a bond, may also be required in
case insolvency proceedings are not subsequently commenced or the measure
sought results in some harm to the debtor’s business. Where provisional
measures are improperly obtained, it may be appropriate to permit the court to
assess costs, fees and damages against the applicant for the measure.

     (iv)   Notice of application and orders for provisional measures
52. The insolvency law may also need to consider the question of provision
of notice, both in respect of an application for provisional measures and of an
order for provisional measures (including the time at which those measures
become effective) and the parties to be notified. As a general principle, the
debtor should be given notice of an application for provisional measures and
an opportunity to challenge the application. Only in exceptional circumstances
is it desirable that notice to the debtor be dispensed with and the application
proceeds on an ex parte basis. While many laws allow ex parte applications
for provisional measures, they generally do so on the basis that the applicant
provides security for costs and damages and can demonstrate requisite
urgency, that is, that irreparable harm will result if the applicant is required to
seek the requested measure under customary procedures requiring many days’
notice.13 Nevertheless, once an order for provisional measures has been made
on an ex parte basis, the debtor would generally be entitled to notice of the
order and an opportunity to be heard. Bearing in mind the need to avoid
unnecessary damage to a debtor against whom insolvency proceedings are not
subsequently commenced, notice of an order for provisional measures may
need to be restricted to parties directly affected by the order. Notice should
also be provided to other parties where their interests will be affected by the
provisional measures being sought.

     (v) Relief from provisional measures
53. Relief from the application of provisional measures, such as modification
or termination, may be appropriate in cases where the interests of the persons
to whom the measures are directed are being harmed by their application.
Examples might include cases involving perishable goods; actions relating to
preservation or quantification of a claim against the debtor; and, in some
situations, secured creditors. The granting of such relief may need to be bal-
anced against potential detriment to the interests of creditors generally or to the
debtor’s assets. Such relief might be available on the application of the affected
party, the insolvency representative or on the motion of the court itself and
would generally require that notice and an opportunity to be heard be given to
the person or persons to be affected by the modification or termination. Where
an order for provisional measures is successfully challenged, the measures
would generally terminate or be modified by the court.



     13
        See UNCITRAL work on court-ordered interim measures in support of arbitration (A/CN.9/
WG.II/WP.119, in the UNCITRAL Yearbook 2002, part two, available at www.uncitral.org).
Part two:    II. Treatment of assets on commencement of insolvency proceedings   93


                      6.    Duration of application of the stay
(a)      Unsecured creditors
54. Many insolvency laws provide that the stay applies to unsecured creditors
throughout both liquidation and reorganization proceedings. In liquidation, this
would generally mean until the liquidation of the assets had been completed
and the proceedings closed. In reorganization, the duration of the proceedings
is not so clear-cut; some laws provide that the proceedings end when the
reorganization plan is approved and effective, while others delay conclusion
until the plan is fully implemented. Application of the stay until that later time
may be unnecessary on the basis that the claims of unsecured creditors should
be addressed in an approved reorganization plan.

55. Relief from the application of the stay may be provided to unsecured
creditors in particular instances such as those noted above with respect to
quantification or preservation of a claim (see above, paras. 33 and 34).

(b)      Secured creditors
   (i)      Reorganization
56. It may be desirable for the stay to apply to secured creditors for a
sufficient period of time to ensure that the reorganization can be conducted in
an orderly manner without the possibility of assets being separated before it
can be determined how those assets should be treated in reorganization and an
appropriate plan approved. To avoid application of the stay for an uncertain or
unnecessarily lengthy period and encourage a speedy resolution of the pro-
ceedings, there may be advantage in limiting the application of the stay to the
time it may reasonably take for a reorganization plan to become effective,
provided that that does not take a significant period of time and the proceed-
ings are not allowed to continue for years without a plan being proposed and
approved. Such a limitation may also have the advantage of providing secured
creditors with a degree of certainty and predictability as to the duration of the
period of postponement of their rights and the treatment of those rights in the
plan. Alternatively a fixed time period might be specified. The difficulty with
that approach, however, is that the time period may not always be sufficiently
long, depending on the size and complexity of the reorganization and the plan
required, and may be difficult to enforce. Solutions may include establishing
clear time limits, with the possibility of extension (see below, para. 58) or
providing for relief from the stay in certain circumstances (see below, paras. 60
and 61). It is important that the overall design of the insolvency law encourage
speedy and efficient progress of the proceedings, enabling the period for
application of the stay to secured creditors, in particular in reorganization, to
be minimized.

   (ii) Liquidation
57. Insolvency laws adopt different approaches to application of the stay to
actions by secured creditors in liquidation. Of those laws applying the stay to
94                                       UNCITRAL Legislative Guide on Insolvency Law


secured creditors, some adopt the approach that the stay automatically applies
upon commencement of liquidation proceedings but only for a brief period,
such as 30 or 60 days. This period is to allow the insolvency representative to
assume its duties, take stock of the assets and liabilities of the estate and
determine the best means of achieving liquidation of the assets. In those cases
where an encumbered asset is essential to the sale of the business as a going
concern, some laws provide that application of the stay may be extended
beyond the specified period. Where the encumbered asset is not required for
the sale of the business, however, the stay could be lifted (see below, para. 60).
Another approach extends the stay to secured creditors for the duration of the
liquidation proceedings, subject to a court order for relief where it can be
shown that the value of the encumbered asset is being eroded and cannot
be maintained.

                 7.    Extension of the duration of the stay
58. As noted above, where the stay applies for a specified period, the law may
include provision for extension. Experience in some countries suggests that
extension of the stay has been treated as a routine matter with the result that
stays have regularly been extended for periods of up to several years, ulti-
mately defeating the purpose of the insolvency proceedings and destroying any
value that may have been available for creditors at the outset. To avoid such
a situation, it is desirable that an insolvency law provide clear rules on the
availability of extensions, limiting the parties that may apply and the grounds
upon which an extension could be granted. An extension may be available, for
example, on the application of the insolvency representative when it can be
demonstrated that it is required in order to maximize value (e.g. there is a
reasonable possibility that the debtor, or business units of the debtor, can be
sold as a going concern), provided that it is not detrimental to the interests of
secured creditors. To provide additional protection and avoid the stay being
applied for an uncertain or unnecessarily lengthy period, it is desirable that an
insolvency law limit the period for which the stay can be extended and,
possibly, the number of times extension is available.

                      8.   Protection of secured creditors
59. As noted above, where secured creditors are included in the scope of the
stay, an insolvency law can adopt certain measures to protect their interests. In
addition to limiting the duration of the stay, these measures may include allow-
ing the stay to be lifted and adopting measures to ensure, where the value of
the secured claim is more than or close to the value of the encumbered asset,
that the value of the encumbered asset is protected against diminution as a
result of the commencement of insolvency proceedings, either as a result of the
use of the asset or because of the application of the stay. Since these measures
are interrelated, it is desirable that an insolvency law adopt a coherent
approach. Where the length of the application of the stay is short, for example,
there may be no need for the law to require protection of the value of encum-
bered assets. Where the stay applies for a long time, however, lifting of the
Part two:   II. Treatment of assets on commencement of insolvency proceedings   95


stay may be a more cost effective remedy than providing protection for the
value of the asset, provided the asset is not required for the proceedings. The
interests of secured creditors can also be protected more generally, by consult-
ing them on the use and sale of the encumbered assets; the payment of interest
as far as the proceeds of the asset allow; and taking over the asset where the
asset is worth less that the secured claim. These measures are discussed in the
following sections. The desirability of approaches that provide protection for
the value of the encumbered asset may need to be weighed against the potential
cost and complexity of those measures, including valuation, and the need for
the court to be able to make difficult commercial decisions on the question of
protection. Where protection is provided, it may be desirable for an insolvency
law to provide guidance on when and how creditors holding some type of
security interest over the debtor’s assets would be entitled to the types
of protection described below.


(a)   Relief from the stay
60. In liquidation and reorganization proceedings, circumstances may arise
where it is appropriate to provide secured creditors with relief from the stay.
For example, the secured creditor may be permitted to apply to the court for
the stay to be lifted or the insolvency representative (without the approval of
the court) may be permitted to release the asset. Relevant circumstances may
include where the value of the secured creditor’s claim exceeds the value of
the encumbered asset; where the secured creditor is not receiving protection for
the diminution in the value of the encumbered asset; where the provision of
protection may not be feasible or would be overly burdensome to the estate;
where the encumbered asset is not needed for the reorganization or sale of the
business as a going concern in liquidation; where relief is required to protect
or preserve the value of assets, such as perishable goods; or where, in reorgani-
zation, a plan is not approved within any applicable time limit.

61. Where relief from the stay is granted, the insolvency law may provide for
the encumbered asset to be turned over to the secured creditor. The asset
ceases to be part of the estate and the secured creditor will be free to enforce
its rights. Under some insolvency laws the insolvency representative may be
required to decide whether the asset should be turned over to the secured
creditor or whether the asset can be relinquished, since the difference between
these options may have cost implications for the estate. For example, where the
asset is a large piece of equipment, turning it over to the creditor may require
expenditure by the estate for transport, while relinquishment places the costs
of removal on the creditor.

62. While provisions on relief from the stay principally address the interests
of secured creditors, there are examples of insolvency laws that provide that
relief from the stay may be granted to an unsecured creditor. This may be
relevant, for example, where goods are perishable and, in those cases where the
insolvency law does not allow commencement or continuation of claims, to
allow a claim to be determined in another forum where litigation may be well
96                                         UNCITRAL Legislative Guide on Insolvency Law


advanced and it would be efficient for it to be completed or for a claim against
an insurer of the debtor to be pursued.

(b)        Protection of value
63. Some insolvency laws adopt provisions specifically designed to address
the negative impact of the stay on secured creditors by maintaining the eco-
nomic value of secured claims during the period of the stay (in some jurisdic-
tions referred to as “adequate protection”). Where the estate is able to maintain
the value of encumbered assets, it can be approached in several ways.

     (i)     Protecting the value of the encumbered asset
64. One approach is to protect the value of the encumbered asset itself on the
understanding that, upon liquidation, the proceeds of sale of the asset will be
distributed directly to the creditor to the extent of the secured portion of their
claim. This approach may require a number of steps to be taken.

65. During the period of the stay it is possible that the value of the encum-
bered asset will diminish. Since, at the time of eventual distribution, the extent
to which the secured creditor will receive priority will be limited by the value
of the encumbered asset, that depreciation can prejudice the secured creditor.
Some insolvency laws provide that the insolvency representative should
protect secured creditors against any diminution either by providing additional
or substitute assets or making periodic cash payments corresponding to the
amount of the diminution in value. This approach is only necessary where
the value of the encumbered asset is less than the amount of the secured claim.
If the value exceeds the claim, the secured creditor will not be harmed by
the diminution of value until that value becomes insufficient to pay the
secured claim. Some States that preserve the value of the encumbered asset as
outlined also allow for payment of interest during the period of the stay to
compensate for delay imposed by the proceedings. Payment of interest may
be limited, however, to the extent that the value of the encumbered asset
exceeds the value of the secured claim. Otherwise, compensation for delay
may deplete the assets available to unsecured creditors. Such an approach may
encourage lenders to seek a security interest that will adequately protect the
value of their claims.

     Valuation of encumbered assets
66. Central to the notion of protecting the value of encumbered assets is the
mechanism for determining the value of those assets to enable the court to
consider whether and how much to provide to secured creditors as relief
against the diminution of the value of encumbered assets during the proceed-
ings. This is a potentially complex issue and involves questions of the basis on
which the valuation should be made (e.g. going concern value or liquidation
value); the party to undertake the valuation; and the relevant date for determin-
ing value, having regard to the purpose for which the valuation is required. In
some cases, the parties may have valued assets before commencement of the
Part two:   II. Treatment of assets on commencement of insolvency proceedings   97


proceedings and that valuation may still be valid at commencement. There may
be a need for an overall valuation shortly after commencement for the purpose
of registering all assets and liabilities and preparing a net balance of the
debtor’s position, so that the insolvency representative will have some idea of
the value of the estate. Assets, in particular encumbered assets, may need to
be valued in the course of proceedings to determine the value of the secured
claim (and any related unsecured claim) and issues of protection related to any
diminution in that value. Assets may also need to be valued in support of the
disposal of segments of the business or of specific assets other than in the
ordinary course of business and at confirmation of an approved reorganization
plan to satisfy applicable requirements. A related issue is the cost of valuation
and the party that should bear that cost.

67. One approach is for the valuation, at least in the first instance, to be
determined through agreement by the parties (being the debtor, or insolvency
representative, and the secured creditor). Other laws provide different court-
based approaches. For example, rather than undertaking the valuation itself, the
court may specify a mode of determining the value, which might be carried out
by appropriate experts. This could be supported by stating clear principles in
the insolvency law as a basis for the valuation. An alternative approach is for
the court, possibly following an initial estimate or appraisal of value by the
insolvency representative, to determine the value on the basis of evidence,
which might include a consideration of markets, market conditions and expert
testimony. Some laws require a market valuation of an asset through sale,
whereby the highest price available in the market for the asset is obtained via
tender or auction. This valuation technique is less applicable to protection of
either the value of the encumbered asset or the secured claim than it is to
disposal of assets of the estate by the insolvency representative.

68. In some liquidation cases, the insolvency representative may find it neces-
sary to use or sell encumbered assets (see below, paras. 83-86) in order to
maximize the value of the estate. For example, to the extent that the insolvency
representative is of the view that the value of the estate can be maximized if
the business continues to operate for a temporary period in liquidation, it may
wish to sell inventory that is partially encumbered. In reorganization proceed-
ings also, it may be in the best interests of the estate to sell encumbered assets
of a similar nature to provide needed working capital. Thus, in cases where
secured creditors are protected by preserving the value of the encumbered
asset, it may be desirable for an insolvency law to allow the insolvency rep-
resentative the choice of providing the creditor with substitute equivalent
security interest, such as a replacement lien over another asset or the proceeds
of the sale of the encumbered asset or paying out the full amount of the value
of the assets that secure the secured claim either immediately or through an
agreed payment plan. Other approaches focus on the use of the proceeds of the
sale of the encumbered assets (see below, paras. 92 and 93). One method is for
the court to prevent current or future use of those proceeds by the insolvency
representative. Other laws grant secured creditors relief from the stay to pursue
individual remedies regarding such proceeds or, where use of the proceeds is
not authorized by either the secured creditor or the court, hold the debtor, its
98                                       UNCITRAL Legislative Guide on Insolvency Law


management or the insolvency representative personally liable for the amount
of the proceeds or make such debt non-dischargeable.

     (ii) Protecting the value of the secured portion of the claim
69. A second approach to protecting the interests of secured creditors is to
protect the value of the secured portion of the claim. Immediately upon com-
mencement, the encumbered asset is valued and, based on that valuation, the
amount of the secured portion of the creditor’s claim is determined. This
amount remains fixed throughout the proceedings and, upon distribution
following liquidation, the secured creditor receives a first-priority claim to the
extent of that amount. During the proceedings, the secured creditor could also
receive the contractual rate of interest on the secured portion of the claim to
compensate for delay imposed by the proceedings. This approach avoids some
of the complexities associated with ongoing valuation of the encumbered
assets that may be required under the first approach noted above.


            9.   Limitations on disposal of assets by the debtor
70. In addition to measures designed to protect the insolvency estate against
the actions of creditors and third parties, insolvency laws generally adopt
measures that are intended to limit the extent to which the debtor can deal with
assets of the estate (see above, para. 16). These measures generally will apply
after proceedings have commenced, but may in some cases also apply between
the application for commencement and commencement itself. For example,
where an interim insolvency representative is appointed as a provisional
measure before commencement of the proceedings, the debtor may be subject
to supervision or control of that insolvency representative, and generally have
limited powers to deal with its assets (see above, para. 50). Under some insol-
vency laws, this period will only occur in the case of a creditor application
because a debtor application will function to automatically commence the
proceedings.

71. Where an insolvency representative is appointed on commencement of the
insolvency proceedings, many insolvency laws provide that the debtor will lose
either all control of the insolvency estate and will not be able to enter into any
transactions after commencement, or will have continuing, but limited, powers
in relation to the day-to-day conduct of the business and can enter into trans-
actions only in the ordinary course of business. Transactions that do not fall
into that category, such as the sale of significant assets that generally would
be outside the ordinary course of business, may require authorization by the
insolvency representative, the court or, in some cases, the creditors.

72. Where the debtor enters into an unauthorized transaction, whether
between application and commencement or after commencement of proceed-
ings, the effect would generally be that any property transferred should be
returned to the insolvency representative and any obligations created would be
unenforceable against the estate. There may be concerns, however, about the
Part two:    II. Treatment of assets on commencement of insolvency proceedings           99


counterparty to the transaction, especially where that party entered into the
transaction in good faith and gave value for what was received. For that reason,
some insolvency laws provide for those transactions to be valid in certain
circumstances. These might include, for example, situations where the transfer
was of an immovable and was made before the commencement of the insol-
vency was notified in the relevant registry or where a third party holding
certain assets of the debtor transferred them to another party in good faith and
without any knowledge of the commencement of insolvency proceedings.
While operating to protect an innocent third party, such a provision neverthe-
less has the potential to reduce the assets available to creditors. For that reason,
it is desirable that if any such provision is to be included in an insolvency law,
it be narrowly framed. Because the delay between commencement and notifi-
cation of commencement can be central to the occurrence of these transfers, it
is essential that the requirements for giving notice of commencement result in
early and effective notification (see chap. I, paras. 64-71).

73. Some insolvency laws address contracts entered into and transactions
implemented by the debtor between application and commencement that are
not authorized, whether by the insolvency law, the insolvency representative,
the court or creditors (as required), in terms of the avoidance provisions, and
apply the suspect period retrospectively from commencement of proceedings
(see below, para. 188).



                                 Recommendations 39-51

     Purpose of legislative provisions
            The purpose of provisions on the protection and preservation of the estate
     is:
         (a) To establish measures to ensure that the value of the estate is not
     diminished by the actions of the debtor, creditors or third parties;
         (b) To determine the scope of those measures and the actions and parties
     to which they apply;
         (c) To establish the method, time and duration of application of those
     measures; and
            (d) To establish the grounds for relief from those measures.

     Contents of legislative provisions
     Provisional measures14 (paras. 47-53)
         39. The insolvency law should specify that the court may grant relief of
     a provisional nature, at the request of the debtor, creditors or third parties,
     where relief is needed to protect and preserve the value of the assets of the


      14
        These articles follow the corresponding articles of the UNCITRAL Model Law on Cross-
Border Insolvency, see article 19 (see annex III).
100                                                 UNCITRAL Legislative Guide on Insolvency Law




      Recommendations 39-51 (continued)
      debtor15 or the interests of creditors, between the time an application to
      commence insolvency proceedings is made and commencement of the pro-
      ceedings,16 including:
          (a) Staying execution against the assets of the debtor, including actions
      to make security interests effective against third parties and enforcement of
      security interests;
           (b) Entrusting the administration or supervision of the debtor’s business,
      which may include the power to use and dispose of assets in the ordinary
      course of business, to an insolvency representative or other person17 designated
      by the court;
           (c) Entrusting the realization of all or part of the assets of the debtor to
      an insolvency representative or other person designated by the court, in order
      to protect and preserve the value of assets of the debtor that, by their nature
      or because of other circumstances, are perishable, susceptible to devaluation or
      otherwise in jeopardy; and
          (d) Any other relief of the type applicable or available on commence-
      ment of proceedings under recommendations 46 and 48.

      Indemnification in connection with provisional measures (para. 51)

           40. The insolvency law may provide the court with the power to:
           (a) Require the applicant for provisional measures to provide indemnifi-
      cation and, where appropriate, to pay costs or fees; or
          (b) Impose sanctions in connection with an application for provisional
      measures.

      Balance of rights between the debtor and insolvency representative
      (paras. 50 and 70-73)

           41. The insolvency law should clearly specify the balance of the rights
      and obligations between the debtor and any insolvency representative
      appointed as a provisional measure. Between the time an application for com-
      mencement of insolvency proceedings is made and commencement of those
      proceedings, the debtor is entitled to continue to operate its business and to use
      and dispose of assets in the ordinary course of business, except to the extent
      restricted by the court.




      15
         The reference to assets in paragraphs (a)-(c) is intended to be limited to assets that would be
part of the insolvency estate once proceedings commence.
      16
         The insolvency law should indicate the time of effect of an order for provisional measures, for
example, at the time of the making of the order, retrospectively from the commencement of the day
on which the order is made or some other specified time (see above, para. 44).
      17
         The term “other person” in recommendation 39, paragraphs (b) and (c), is not intended to
include the debtor.
Part two:   II. Treatment of assets on commencement of insolvency proceedings                     101




     Notice (para. 52)
          42. The insolvency law should specify that, unless the court limits or
     dispenses with the need to provide notice, appropriate notice is to be given to
     those parties in interest affected by:
          (a) An application or court order for provisional measures (including an
     application for review and modification or termination); and
          (b) A court order for additional measures applicable on commencement,
     unless the court limits or dispenses with the need to provide notice.

     Ex parte provisional measures (para. 52)
          43. The insolvency law should specify that, where the debtor or other
     party in interest affected by a provisional measure is not given notice of the
     application for that provisional measure, the debtor or other party in interest
     affected by the provisional measures has the right, upon urgent application, to
     be heard promptly18 on whether the relief should be continued.

     Modification or termination of provisional measures (para. 53)
          44. The insolvency law should specify that the court, at its own motion
     or at the request of the insolvency representative, the debtor, a creditor or any
     other person affected by the provisional measures, may review and modify or
     terminate those measures.

     Termination of provisional measures (para. 53 and chap. I, para. 63)
          45. The insolvency law should specify that provisional measures termi-
     nate when:
         (a) An application for commencement is denied;
         (b) An order for provisional measures is successfully challenged under
     recommendation 43; and
         (c) The measures applicable on commencement take effect, unless the
     court continues the effect of the provisional measures.

     Measures applicable on commencement (paras. 30-34)
         46. The insolvency law should specify that, on commencement of insol-
     vency proceedings:19
          (a) Commencement or continuation of individual actions or proceed-
     ings20 concerning the assets of the debtor and the rights, obligations or liabili-
     ties of the debtor are stayed;


      18
        Any time limit included in the insolvency law should be short in order to prevent the loss of
value of the debtor’s business.
      19
        These measures would generally be effective as at the time of the making of the order for
commencement.
      20
        See UNCITRAL Model Law on Cross-Border Insolvency, article 20 (see annex III). It is
intended that the individual actions referred to in subparagraph (a) of recommendation 46 would also
cover actions before an arbitral tribunal. It may not always be possible, however, to implement the
automatic stay of arbitral proceedings, such as where the arbitration does not take place in the State
but in a foreign location.
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      Recommendations 39-51 (continued)

           (b) Actions to make security interests effective against third parties and
      to enforce security interests are stayed;21
           (c) Execution or other enforcement against the assets of the estate is
      stayed;
           (d) The right of a counterparty to terminate any contract with the debtor
      is suspended;22 and
           (e) The right to transfer, encumber or otherwise dispose of any assets of
      the estate is suspended.23

      Exceptions to application of the stay (para. 35)
           47. The insolvency law may permit exceptions to the application of the
      stay or suspension under recommendation 46 and, where it does so, those
      exceptions should be clearly stated. Paragraph (a) of recommendation 46
      should not affect the right to commence individual actions or proceedings to
      the extent necessary to preserve a claim against the debtor.24

      Additional measures available on commencement (para. 34)
           48. The insolvency law should specify that the court may grant relief
      additional to the measures applicable on commencement.25

      Duration of measures automatically applicable on commencement
      (paras. 54-58)
          49. The insolvency law should specify that the measures applicable on
      commencement of insolvency proceedings remain effective throughout those
      proceedings until:


       21
          If law other than the insolvency law permits those security interests to be made effective
within certain specified time periods, it is desirable that the insolvency law recognize those periods
and permit the interest to be made effective where the commencement of insolvency proceedings
occurs before expiry of the specified time period. Where law other than the insolvency law does not
include such time periods, the stay applicable on commencement would operate to prevent the security
interest being made effective. (For further discussion see above, paragraph 32, and the UNCITRAL
Legislative Guide on Secured Transactions.)
       22
          See below, paras. 114-119. This recommendation is not intended to preclude the termination
of a contract if the contract provides for a termination date that happens to fall after the commence-
ment of insolvency proceedings.
       23
          The limitation on the right to transfer, encumber or otherwise dispose of assets of the estate
may be subject to an exception in those cases where the continued operation of the business by the
debtor is authorized and the debtor can transfer, encumber or otherwise dispose of assets in the
ordinary course of business.
       24
          See UNCITRAL Model Law on Cross-Border Insolvency, art. 20, para. 3, and Guide to
Enactment, paras. 151 and 152 (see annex III). Where an issue arises as to quantification of a claim,
the court may be requested to consider whether relief from the stay can be provided to enable an action
or proceeding to be commenced for that purpose.
       25
          The additional relief that may be available will depend upon the types of measure available
in a particular jurisdiction and what measures, in addition to the measures applicable on commence-
ment (such as under recommendation 46), might be appropriate in a particular insolvency proceeding.
Part two:    II. Treatment of assets on commencement of insolvency proceedings                      103




            (a) The court grants relief from the measures;26
          (b) In reorganization proceedings, a reorganization plan becomes effec-
     tive;27 or
          (c) In the case of secured creditors in liquidation proceedings, a fixed
     time period specified in the law expires,28 unless it is extended by the court for
     a further period on a showing that:
                (i) An extension is necessary to maximize the value of assets for
                     the benefit of creditors; and
               (ii) The secured creditor will be protected against diminution of
                     the value of the encumbered asset in which it has a security
                     interest.

     Protection from diminution of the value of encumbered assets (paras. 63-69)
          50. The insolvency law should specify that, upon application to the court,
     a secured creditor should be entitled to protection of the value of the asset in
     which it has a security interest. The court may grant appropriate measures of
     protection that may include:
            (a) Cash payments by the estate;
            (b) Provision of additional security interests; or
            (c) Such other means as the court determines.

     Relief from measures applicable on commencement (paras. 60-62)
         51. The insolvency law should specify that a secured creditor may
     request the court to grant relief from the measures applicable on commence-
     ment of insolvency proceedings on grounds that may include that:
          (a) The encumbered asset is not necessary to a prospective reorganiza-
     tion or sale of the debtor’s business;
          (b) The value of the encumbered asset is diminishing as a result of the
     commencement of insolvency proceedings and the secured creditor is not
     protected against that diminution of value; and
          (c) In reorganization, a plan is not approved within any applicable time
     limits.




      26
         Relief should be granted on the grounds included in recommendation 51.
      27
         A plan may become effective upon approval by creditors or following confirmation by the
court, depending upon the requirements of the insolvency law (see chap. IV, paras. 54 and following).
       28
         It is intended that the stay should apply to secured creditors only for a short period of time,
such as between 30 and 60 days, and that the insolvency law should clearly state the period of
application.
104                                                UNCITRAL Legislative Guide on Insolvency Law


                           C.     Use and disposal of assets
                                       1.    Introduction
74. Although as a general principle it is desirable that an insolvency law not
interfere unduly with the ownership rights of third parties or the interests of
secured creditors, the conduct of insolvency proceedings will often require
assets of the insolvency estate, and assets in the possession of the debtor being
used in the debtor’s business, to continue to be used or disposed of (including
by way of encumbrance) in order to enable the goal of the particular proceed-
ings to be realized. This will be especially important in reorganization, but also
in liquidation where the business is to be sold as a going concern. It may also
be relevant in some cases of liquidation where the business needs to be con-
tinued for a short period to enable the value of the assets to be maximized even
if they are to be sold piecemeal. For these reasons, it is desirable that an
insolvency law include provisions on the use or disposal of assets of the
insolvency estate (including encumbered assets), and third-party-owned assets,
addressing the conditions upon which those assets may be used or disposed of
and the provision of protection for the interests of third-party owners and
secured creditors. Sale or disposal of assets would typically involve notifying
creditors, whether generally or only affected creditors, of any proposed action.
Where notice is to be given to creditors generally, it may be provided through
any creditor committee formed to facilitate the proceedings (see chap. III,
paras. 99-112). It may be important to note, in designing provisions on use and
disposal, that other laws may affect the use of these powers in insolvency. For
example, laws prohibiting or restricting foreign ownership in certain sectors of
the economy may limit the price that can be obtained for certain assets and in
turn affect distributions to creditors.

                          2.    Assets of the insolvency estate
(a)    Ordinary course of business
75. Some insolvency laws draw a distinction between use or disposal of assets
of the estate in the ordinary course29 of conducting the business of the debtor
and use or disposal in other circumstances (“outside the ordinary course of
business”) in terms of who may make decisions as to use or disposal and the
protections that are required. When the insolvency representative continues the
operation of the debtor’s business, either during reorganization proceedings or
to enable a sale of the business as a going concern, decisions as to use and
disposal of property in the ordinary course of business may be taken by the


       29
          This concept is discussed further in the context of avoidance proceedings; see below, paras.
164-168. States define the “ordinary course of business” with a varying emphasis on different ele-
ments. However, in most jurisdictions a common purpose of the definition is to determine what
constitutes routine conduct of business and allow a business to make routine payments and enter into
routine contracts, without subjecting those transactions to possible avoidance in insolvency. Those
routine payments might include the payment of rent, utilities such as electricity and telephone and
possibly also payment for trade supplies.
Part two:   II. Treatment of assets on commencement of insolvency proceedings                        105


insolvency representative30 without requiring notice to be given to creditors or
approval of the court. Use and disposal outside the ordinary course of business,
however, may require approval of the court or of creditors. Some laws extend
these rights of use and disposal to a debtor under the supervision or control of
an insolvency representative or to a debtor-in-possession. When the assets are
subject to a security or other interest (e.g. a lease) the economic rights of the
holder of that interest will need to be protected.

76. Including a distinction in the insolvency law between disposals made in
or outside the ordinary course of business may facilitate the continuing day-
to-day operation of the business, both in reorganization and in liquidation
where it is to be sold as a going concern, without imposing the complexity of
obtaining court approval to conduct routine activities. The requirement for
approval in the case of non-routine disposal can act as a check against abuse,
such as disposals to related parties. Nevertheless, an insolvency law needs to
provide clear guidance on what constitutes dealing in the ordinary course of
business in order to avoid disputes and ensure that the proceedings are con-
ducted quickly and efficiently. Sale or other disposal of assets outside the
ordinary course of business raises several complicated issues, which are
discussed below, including the method of sale designed to generate the most
value for the estate; the sale of encumbered assets when there is a dispute
concerning the validity or amount of the secured claim or when the value of
the estate will be enhanced by that sale; notice to parties in interest and an
opportunity for interested buyers to submit higher and better offers; prompt
sale in the case of perishable assets; and the power to abandon assets that have
no value to the estate.

77. Some insolvency laws also distinguish between different types of asset in
terms of how they may be used and the conditions that will apply. Special
provisions may apply, for example, to perishable or other assets that will
diminish in value if not sold quickly or to cash or to property held jointly by
the debtor and another person or held by the debtor subject to a security
interest. An insolvency law may provide that such assets can be sold outside
the ordinary course of business without prior approval of creditors or of the
court.

78. Any concerns with respect to possible misuse of powers of use and
disposal or defalcation by the insolvency representative may be addressed in
terms of the appointment criteria, including provision of a security bond (an
approach adopted by many insolvency laws—see also chap. III, para. 62)
and through other measures to address the liability of the insolvency
representative.


      30
        The exercise of these rights by the insolvency representative depends upon the functions of
that position under the insolvency law and may be restricted, for example, where the insolvency
representative’s role is that of a trustee or supervisor and also upon the relative roles assigned to the
debtor and insolvency representative after commencement of insolvency proceedings, in particular in
reorganization.
106                                      UNCITRAL Legislative Guide on Insolvency Law


(b)   Methods of sale
79. Where assets of the insolvency estate are to be sold it is important that,
irrespective of which party may be required to supervise sales, the manner of
sale chosen maximizes the value for the estate and that creditors receive
adequate notice of the sale, enabling them to challenge the sale in court if they
disapprove. Where a creditor committee is formed and the insolvency law
provides for creditors to be consulted on the sale of assets outside the ordinary
course of business, a requirement to notify creditors of any proposed sale
might be satisfied by notifying the creditor committee in order to minimize
costs and avoid any delay associated with notifying all creditors. Different
procedures are adopted with respect to the sale of assets. Many insolvency
laws require assets to be sold by auction, with some providing that the creditor
committee, or some other creditor representative or the insolvency representa-
tive, can approve some other means of sale, such as by private contract, if it
will be more profitable.


80. As noted above, some insolvency laws give the power of sale in the
ordinary course of business to the insolvency representative and impose a
duty to obtain the best price reasonably obtainable at the time of sale. Some
of those laws also impose limits on the insolvency representative’s discretion
to choose the method of sale. In cases where the insolvency representative
chooses to conduct the sale privately rather than through a public auction,
the law may require the court to supervise the sale or creditors to approve it.
Other insolvency laws provide for the court to play a significant role in the
sale of assets. The court fixes the time, the form and the conditions of sale;
the insolvency representative plays a subsidiary role in collecting offers and
obtaining the views of the creditors. Some insolvency laws also address
issues such as sales to a creditor to offset that creditor’s claim and sale of any
of the debtor’s assets in the possession of a third party to that third party
for a reasonable market price. Where assets might be subject to rapid
deterioration of value, such as where they are perishable, susceptible to devalu-
ation or otherwise in jeopardy, notification and/or approval of creditors or
the court might prove difficult to achieve quickly. In such cases it may be
desirable for the law to provide that prior approval is not necessary. While
the sale could be confirmed after it has been completed, it would not be
feasible to create a possibility of reversing or modifying the sale (except
in cases of fraud or collusion) because of the consequential contractual
uncertainty, and the very nature of the assets may discount the likelihood of
any resale.


81. Although it may be suggested that an insolvency law should specifically
preclude a sale to related parties to avoid collusion, absolute prohibition of
such a sale may not be necessary, provided it is adequately supervised and
carefully scrutinized before being allowed to proceed, to avoid fraud and
collusion. Such supervision or scrutiny may require higher standards in terms
of the valuation of assets and disclosure of business relationships.
Part two:   II. Treatment of assets on commencement of insolvency proceedings   107


82. While it may be expected that assets sold in the context of insolvency
proceedings will achieve a lower sale price than similar assets sold under
normal market conditions, an insolvency law can adopt a number of procedural
protections to ensure that the proceedings are fair, that the maximum price is
achieved and that, overall, the procedure for disposal of assets is transparent
and well-publicized. Such protections include providing notice to creditors and
to prospective purchasers in a manner that will ensure the information is likely
to come to the attention of interested parties; allowing creditors to raise their
objections or concerns (either with the insolvency representative or the court,
as appropriate); requiring assets to be valued by neutral, independent
professionals (especially in the case of real estate and specialized property);
and, in the case of auctions, requiring pre-bidding qualification and minimum
prices where appropriate and preventing and punishing collusion among
bidders.


(c)   Use or disposal of encumbered assets
83. An insolvency law will need to address the question of use or disposal
(including by further encumbrance) of encumbered assets and, in particular,
whether the insolvency representative or the secured creditor will have the
power to sell those assets. To a large extent, the approach adopted will depend
upon whether the insolvency law includes encumbered assets in the insolvency
estate; if not, the secured creditor will generally be free to enforce its security
interest. Where encumbered assets are part of the estate, insolvency laws take
different approaches to the issue. In some cases, the approach depends upon
the application of other provisions of the insolvency law, such as application
of the stay (while the stay applies only the insolvency representative can dis-
pose of the assets), as well as law other than insolvency law, and whether
encumbered assets can be sold free and clear of interests. It may also depend
on the nature of the sale proposed, whether as an individual asset or as an
integral part of a sale of the business as a going concern. Some insolvency
laws, for example, provide that only the insolvency representative will be able
to dispose of encumbered assets in both liquidation and reorganization. Other
laws distinguish between liquidation and reorganization; the insolvency repre-
sentative will be able to dispose of the assets during reorganization, but in
liquidation this ability is time-limited. Once the insolvency representative’s
exclusive period has expired, the secured creditor may exercise its rights.
Whichever approach is adopted, an insolvency law should require secured
creditors to be notified of any proposed disposal and have an opportunity to
object. Where the secured claim exceeds the value of the asset or the asset is
not required for the proceedings, the insolvency representative may be
permitted to relinquish the encumbered asset to the secured creditor without
notice.

84. An insolvency law should also outline the conditions (including provision
of notice and an opportunity for existing secured creditors to object) for further
encumbrance of already encumbered assets, the most common being that the
108                                        UNCITRAL Legislative Guide on Insolvency Law


existing secured creditor will have priority for the secured portion of its claim
over any new secured creditor (see below, paras. 103 and 104).


(d)   Ability of the insolvency representative to sell free
      and clear of interests
85. Some insolvency laws permit the insolvency representative to sell assets
of the estate free and clear of interests, including security interests, subject to
certain conditions. These may include that the sale is permitted under law other
than the insolvency law; that the holder of the interest is notified of the pro-
posed sale and consents; that the sale price is in excess of the value of the
security interest; that the holder of the security interest could be compelled (in
other legal proceedings) to accept cash or substitute equivalent security interest
in settlement of its interest; and that the priority of interests in the proceeds of
any sale will be preserved. Some laws also provide that, where the holder of
the security interest does not consent to the sale, the insolvency representative
may request the court to authorize the sale. This may be granted provided the
court is satisfied, for example, that the insolvency representative has made
reasonable efforts to obtain the consent; that the sale is in the interests of the
debtor and its creditors; and that the sale will not substantially prejudice the
holder of the interest. Even where the court approves the sale, if the offer for
the asset was inadequate, the law might permit the holder of the security
interest to retain the right to offset the bid to protect its interest.

86. Some advantages of allowing the insolvency representative to sell free
and clear are that assets sold subject to these interests are likely to obtain
much lower prices and considerable uncertainty will exist for the buyer.
Where encumbered assets are subject to conflicting claims (e.g. ownership,
lease or lien), the ability to sell free and clear of interests will allow the assets
(where they are not unique) to be sold without waiting for the claims to be
resolved. The claimants can then dispute the distribution of the proceeds
of sale.


(e)   Joint assets
87. Where the debtor and another person own assets in some form of joint or
co-ownership, different approaches may be taken to the disposal of the estate’s
interest. Where the assets can be divided, generally under law other than
insolvency law, between the debtor and the co-owners for the purposes of
execution, the estate’s interest can be sold without affecting the co-owners.
Some insolvency laws, however, provide that the insolvency representative
may sell both the estate’s interest and that of the co-owners, provided certain
conditions are met. These conditions may include that division of the property
between the estate and the co-owners is impractical; that the sale of a divided
part would realize significantly less for the estate than a sale of the undivided
whole free of the interests of the co-owners; and that the benefit to the estate
of such a sale outweighs any detriment to the co-owner. An insolvency law
Part two:   II. Treatment of assets on commencement of insolvency proceedings   109


may also provide that the co-owner has an option or right to purchase the
debtor’s interest before completion of the sale to another party. As noted above
(paras. 20 and 21), the disposal of such assets in insolvency may be affected
by the application of law other than insolvency law.


(f)   Burdensome, no-value and hard-to-realize assets
88. It may be consistent with the objective of maximizing value and reducing
the costs of the proceedings to allow the insolvency representative to relinquish
the estate’s interest in certain assets, including land, shares, assets subject to
a valid security interest, contracts and other property, where the insolvency
representative determines relinquishment to be in the interests of the estate and
additionally where a secured creditor obtains relief from the stay. The exercise
of that power may be subject to approval by the court and to certain conditions,
such as that the relinquishment does not violate any compelling public interest
that may exist, for example, where the asset is environmentally dangerous or
hazardous to public health and safety. An insolvency law may also need to
address who might be entitled to claim the relinquished assets. Situations in
which this approach may be appropriate include where assets are of no or an
insignificant value to the estate (e.g. the security interest exceeds the value of
the encumbered asset); where the asset is burdened in such a way that retention
would require excessive expenditure that would exceed the proceeds of reali-
zation of the asset or give rise to an onerous obligation or a liability to pay
money; or where the asset is unsaleable or not readily saleable by the insol-
vency representative, such as where the asset is unique or does not have a
readily apparent market or market value. Where a secured creditor is given an
asset relinquished by an insolvency representative, the insolvency law might
provide that the secured creditor’s claim is reduced by the value of the relin-
quished asset. Creditors should be provided with notice of, and given an
opportunity to object to, any proposal by the insolvency representative to
relinquish assets.


(g)   Receivables
89. Where the assets of the estate include receivables (the debtor’s contractual
right to payment of a monetary sum), permitting the insolvency representative
to assign the rights to payment may enable value or a credit to be obtained for
the estate. Different approaches are taken to the question of assignment in the
context of insolvency (see below, paras. 139-142). Some insolvency laws
specify that non-assignment clauses are made null and void by the commence-
ment of insolvency proceedings. Other insolvency laws leave the matter to
general contract law. If the contract contains a non-assignment clause the
contract cannot be assigned unless the parties to the original contract agree.
Some laws also provide that, if the counterparty to the original contract does
not consent to assignment, the insolvency representative may assign with
permission from the court if it can be shown that the counterparty is withhold-
ing consent unreasonably. This approach is consistent with the approach taken
110                                                   UNCITRAL Legislative Guide on Insolvency Law


in the United Nations Convention on the Assignment of Receivables in
International Trade, article 9.31

                               3.     Third-party-owned assets
90. There will be insolvency cases where third-party-owned assets, similarly
to encumbered assets, may be crucial to the continued operation of the busi-
ness, in particular in reorganization proceedings but also to a lesser extent in
those liquidation proceedings where the business is to be sold as a going
concern. In those cases, it will be advantageous for the insolvency proceedings
if an insolvency law includes a mechanism that will enable such assets to
continue to be used. Some insolvency laws address this issue in terms of the
types of asset to be included as part of the insolvency estate (see above, paras.
10-12 and 17) and therefore available for use by the insolvency representative.
It should be noted that, for the purposes of the Legislative Guide, the debtor’s
interests in third-party-owned assets are considered to be assets. Other insol-
vency laws, where the possession of the asset by the debtor is subject to a
contractual arrangement, address the question of use in the context of the
treatment of contracts. This may include, for example, imposing restrictions on
the termination of the contract pursuant to which the debtor holds the assets
(see below, paras. 114-119) or preventing the owner from reclaiming its assets
in the insolvency (at least without the approval of the court or the insolvency
representative) for a limited period of time after commencement through ap-
plication of a stay.

91. Where third-party-owned assets are used in the insolvency proceedings,
an insolvency law will need to consider protection of the interests of the owner
of the assets against diminution in their value, in much the same way as
protection is provided against diminution in the value of encumbered assets
(see above, paras. 63-69). It is desirable that claims arising from the continued
use of the asset be paid by the estate as an administrative expense (see below,
para. 131).

      31
         Article 9, Contractual limitations on assignment, reads:
            “1. An assignment of a receivable is effective notwithstanding any agreement between
      the initial or any subsequent assignor and the debtor or any subsequent assignee limiting in any
      way the assignor’s right to assign its receivables.
            “2. Nothing in this article affects any obligation or liability of the assignor for breach
      of such an agreement, but the other party to such agreement may not avoid the original contract
      or the assignment contract on the sole ground of that breach. A person who is not party to such
      an agreement is not liable on the sole ground that it had knowledge of the agreement.
            “3. This article applies only to assignments of receivables:
            “(a) Arising from an original contract that is a contract for the supply or lease of goods
      or services other than financial services, a construction contract or a contract for the sale or lease
      of real property;
            “(b) Arising from an original contract for the sale, lease or licence of industrial or other
      intellectual property or of proprietary information;
            “(c) Representing the payment obligation for a credit card transaction; or
            “(d) Owed to the assignor upon net settlement of payments due pursuant to a netting
      agreement involving more than two parties.”
Part two:    II. Treatment of assets on commencement of insolvency proceedings          111


                           4.    Treatment of cash proceeds
92. Where “liquid” encumbered assets (i.e. encumbered assets, such as inven-
tory, that are easily converted to cash) are sold in the course of insolvency
proceedings, most laws provide that a secured creditor with an interest in those
encumbered assets continues to hold an equivalent interest in any cash derived
from the disposal of those assets.

93. Those cash proceeds can represent an important source of capital for the
insolvency estate during the course of insolvency proceedings, especially in
reorganization, and may be used for a number of purposes associated with the
running of the business, such as payment of electricity and other service
charges. In order to use cash proceeds, an insolvency representative must
generally pursue one of two courses of action. Cash proceeds may be used with
the consent of the relevant secured creditor on the terms agreed between the
parties or, alternatively, following provision of notice to affected creditors, the
debtor may seek court approval to use the cash proceeds. In general, a court
will need to determine a number of matters before authorizing such use: both
the relevant security interest and the value of the underlying property; the risk
to the secured creditor; and whether sufficient measures are in place to protect
the economic value of the secured claim (see above, paras. 63-69).



                                 Recommendations 52-62

     Purpose of legislative provisions

            The purpose of provisions on use and disposal of assets is to:
         (a) Permit the use and disposal of assets, including encumbered assets in
     the insolvency proceedings and specify the conditions for their use and
     disposal;
          (b) Permit and specify the conditions for the use of third party owned
     assets;
            (c) Establish the limits to powers of use and disposal;
            (d) Notify creditors of proposed use and disposal, where appropriate; and
            (e) Provide for the treatment of burdensome assets.

     Contents of legislative provisions
     Power to use and dispose of assets of the estate (para. 74)
            52. The insolvency law should permit:
          (a) The use and disposal of assets of the estate (including encumbered
     assets) in the ordinary course of business, except cash proceeds; and
          (b) The use and disposal of assets of the estate (including encumbered
     assets) outside the ordinary course of business, subject to the requirements of
     recommendations 55 and 58.
112                                                  UNCITRAL Legislative Guide on Insolvency Law




      Recommendations 52-62 (continued)

      Further encumbrance of encumbered assets (para. 84)
           53. The insolvency law should specify that an encumbered asset may be
      further encumbered, subject to the requirements of recommendations 65-67.

      Use of third-party-owned assets (paras. 90-91)
          54. The insolvency law should specify that the insolvency representative
      may use an asset owned by a third party and in the possession of the debtor
      provided specified conditions are satisfied, including:
           (a) The interests of the third party will be protected against diminution
      in the value of the asset; and
          (b) The costs under the contract of continued performance of the contract
      and use of the asset will be paid as an administrative expense.

      Procedure for notification of disposal (para. 82)
          55. The insolvency law should specify that adequate notice of any dis-
      posal conducted outside the ordinary course of business be given to creditors32
      and that they have the opportunity to be heard by the court.

           56. The insolvency law should specify that notification of public auctions
      be provided in a manner that will ensure that the information is likely to come
      to the attention of interested parties.

      General methods of sale (paras. 79-82)
           57. The insolvency law should specify methods of sale for sales con-
      ducted outside the ordinary course of business that will maximize the price
      obtained for assets being sold in insolvency proceedings, and permit both
      public auctions and private sales.

      Ability to sell assets of the estate free and clear of encumbrances and
      other interests (paras. 85 and 86)
           58. The insolvency law should permit the insolvency representative to
      sell an asset that is encumbered or subject to other interest free and clear of
      that encumbrance and other interest, outside the ordinary course of business,
      provided that:
          (a) The insolvency representative gives notice of the proposed sale to the
      holders of encumbrances or other interests;
          (b) The holder is given the opportunity to be heard by the court where
      they object to the proposed sale;
             (c) Relief from the stay has not been granted; and
           (d) The priority of interests in the proceeds of sale of the asset is
      preserved.


      32
           When the assets are encumbered assets or subject to other interests, recommendation 58 also
applies.
Part two:   II. Treatment of assets on commencement of insolvency proceedings           113




     Use of cash proceeds (paras. 92 and 93)
         59. The insolvency law should permit the insolvency representative to
     use and dispose of cash proceeds if:
         (a) The secured creditor with a security interest in those cash proceeds
     consents to such use or disposal; or
         (b) The secured creditor was given notice of the proposed use or disposal
     and an opportunity to be heard by the court; and
          (c) The interests of the secured creditor will be protected against dimi-
     nution in the value of the cash proceeds.

     Urgent sales (para. 77 and 80)
          60. The insolvency law should permit the urgent sale of an asset to be
     conducted outside the ordinary course of business, where the asset is, by its
     nature or because of other circumstances, perishable, susceptible to devalua-
     tion or otherwise in jeopardy. The insolvency law may provide that prior
     approval of the court or of creditors is not required in such circumstances.

     Disposal of assets to related persons (para. 81)
          61. The insolvency law should require any proposed disposal of an asset
     to a related person to be carefully scrutinized before being allowed to proceed.

     Burdensome assets (para. 88)
          62. The insolvency law should permit the insolvency representative to
     determine the treatment of any asset that is burdensome to the estate. In parti-
     cular, the insolvency law may permit the insolvency representative to relin-
     quish a burdensome asset following the provision of notice to creditors and the
     opportunity for creditors to object to the proposed action, except that where a
     secured claim exceeds the value of the encumbered asset and the asset is not
     required for a reorganization or sale of the business as a going concern, the
     insolvency law may permit the insolvency representative to relinquish the asset
     to the secured creditor without notice to other creditors.




                         D.    Post-commencement finance
                    1.   Need for post-commencement finance
94. The continued operation of the debtor’s business after the commencement
of insolvency proceedings is critical to reorganization and, to a lesser extent,
liquidation where the business is to be sold as a going concern. To maintain
its business activities, the debtor must have access to funds to enable it to
continue to pay for crucial supplies of goods and services, including labour
costs, insurance, rent, maintenance of contracts and other operating expenses,
as well as costs associated with maintaining the value of assets. In some
insolvency cases, the debtor may already have sufficient liquid assets to fund
the ongoing business expenses in the form of cash or other assets that can be
114                                      UNCITRAL Legislative Guide on Insolvency Law


converted to cash (such as anticipated proceeds of receivables). Alternatively,
those expenses can be funded out of the debtor’s existing cash flow through
operation of the stay and cessation of payments on pre-commencement liabili-
ties. Where the debtor has no available funds to meet its immediate cash flow
needs, it will have to seek financing from third parties. This financing may take
the form of trade credit extended to the debtor by vendors of goods and
services or loans or other forms of finance extended by lenders.

95. To ensure the continuity of the business where this is the object of the
proceedings, it is highly desirable that a determination on the need for new
finance be made at an early stage, in some cases even in the period between
the time the application is made and commencement of proceedings. The
availability of new finance will also be important in reorganization proceedings
between commencement of the proceedings and approval of the plan; obtain-
ing finance in the period after approval of the plan should generally be
addressed in the plan, especially in those jurisdictions which prohibit new
borrowing unless the need for it is identified in the plan.

96. Notwithstanding that it might be beneficial to the outcome of the proceed-
ings for the debtor to be able to obtain new money, a number of jurisdictions
restrict the provision of new money in insolvency or do not specifically
address the issue of new finance or the priority for its repayment in insolvency,
which creates uncertainty. Under some laws, for example, new money can only
be provided on the basis of a security interest, as provision of a preference for
new lending is prohibited. In those cases where there are no unencumbered
assets, or no excess value in already encumbered assets, that the debtor can
offer as security or with which the debtor can satisfy an administrative expense
priority claim, the debtor has limited options. No new money will be available
unless the lender is prepared to take the risk of lending without security or
unless it can be obtained from sources such as the debtor’s family or group
companies. In the absence of enabling or clarifying treatment in the insolvency
law, the provision of finance in the period before commencement of the insol-
vency proceedings may also raise difficult questions relating to the application
of avoidance powers and the liability of both the lender and the debtor. Some
insolvency laws provide, for example, that where a lender advances funds to
an insolvent debtor in that period, it may be responsible for any increase in the
liabilities of other creditors or the advance will be subject to avoidance in any
ensuing insolvency proceedings. In other examples, the insolvency representa-
tive is required to borrow the money, potentially involving questions of
personal liability for repayment.

97. Where an insolvency law promotes the use of insolvency proceedings that
permit the insolvent business to continue trading, whether reorganization or
sale of the business in liquidation as a going concern, it is essential that the
issue of new funding is addressed and limitations such as those discussed
above are considered. An insolvency law can recognize the need for such post-
commencement finance, provide authorization for it and create priority or
security for repayment of the lender. The central issue is the scope of the
power and, in particular, the inducements that can be offered to a potential
Part two:   II. Treatment of assets on commencement of insolvency proceedings   115


creditor to encourage it to lend. To the extent that the solution adopted has an
impact on the rights of existing secured creditors or those holding an interest
in assets that was established prior in time, it is desirable that provisions
addressing post-commencement finance be balanced against a number of
factors. These include the general need to uphold commercial bargains; protect
the pre-existing rights and priorities of creditors; and minimize any negative
impact on the availability of credit, in particular secured finance, that may
result from interfering with those pre-existing security rights and priorities. It
is also important to consider the impact on unsecured creditors who may see
the remaining unencumbered assets disappear to secure new lending, leaving
nothing available for distribution, especially if the reorganization were to fail.
This risk must be balanced against the prospect that preservation of going
concern value by continued operation of the business will benefit those
creditors.

98. In addition to issues of availability and priority or security for new lend-
ing, an insolvency law will need to consider the authorization required to
obtain that new money (see below, paras. 105 and 106) and, where a reorgani-
zation fails and the proceedings are converted to liquidation, the treatment of
funds that may have been advanced before the conversion (see below,
para. 107).

                  2.    Sources of post-commencement finance
99. Post-commencement lending is likely to come from a limited number of
sources. The first is pre-insolvency lenders or vendors of goods who have an
ongoing relationship with the debtor and its business and may advance new
funds or provide trade credit in order to enhance the likelihood of recovering
their existing claims and perhaps gaining additional value through the higher
rates charged for the new lending. A second type of lender has no pre-insol-
vency connection with the business of the debtor and is likely to be motivated
only by the possibility of high returns. The inducement for both types of lender
is the certainty that special treatment will be accorded to the post-commence-
ment finance. For existing lenders there are the additional inducements of the
ongoing relationship with the debtor and its business, the assurance that the
terms of their pre-commencement lending will not be altered and, under some
laws, the possibility that, if they do not provide post-commencement finance,
their priority may be displaced by the lender who does provide that finance.

                  3.    Attracting post-commencement finance:
                           providing priority or security
100. A number of different approaches can be taken to attracting post-
commencement finance and providing for repayment. Trade credit or indebted-
ness incurred in the ordinary course of business by an insolvency representa-
tive (or a debtor in possession) may be treated automatically as an
administrative expense. When obtaining credit or incurring indebtedness is
essential to maximizing the value of assets, and the credit or finance is not
116                                       UNCITRAL Legislative Guide on Insolvency Law


otherwise available as an administrative expense or is to be incurred outside
the ordinary course of business, the court may authorize that credit or debt to
be incurred as an administrative expense, to be afforded super-priority ahead
of other administrative expenses or to be supported by the provision of security
on unencumbered or partially encumbered assets.

(a)   Establishing priority
101. Where the business of the debtor continues to operate after commence-
ment of insolvency proceedings, either incidental to an attempted reorganiza-
tion or to preserve value by sale as a going concern, the expenses incurred in
the operation of the business are typically entitled, under a number of insol-
vency laws, to be paid as administrative expenses. Administrative priority
creditors do not rank ahead of a secured creditor with respect to its security
interest, but generally are afforded a first priority (see chap. V, paras. 45-47
and 66) that ranks ahead of ordinary unsecured creditors and any statutory
priorities, for example, taxes or social security claims. Suppliers of goods and
services would only continue to supply those goods and services to the insol-
vency representative on credit if they had a reasonable expectation of payment
ahead of pre-commencement unsecured creditors. In some cases, such a prior-
ity is afforded on the basis that the new credit or lending is extended to the
insolvency representative, rather than to the debtor, and thus becomes an
expense of the insolvency estate. Some insolvency laws require such borrow-
ing or credit to be approved by the court or by creditors, while other laws
provide that the insolvency representative may obtain the necessary credit or
finance without approval. This may involve an element of personal liability for
the insolvency representative and, where it does, is likely to result in reluctance
to seek new finance.

102. Other insolvency laws provide for a “super” administrative priority if
credit or finance is not available where it is ranked as an administrative claim
that is pari passu with other administrative claims such as fees of the insol-
vency representative or professional employed in the case. The “super” priority
ranks ahead of administrative creditors.

(b)   Granting security
103. Where the lender requires security, it can be provided on unencumbered
assets or as a junior or lower security interest on already encumbered assets
where the value of the encumbered asset is sufficiently in excess of the amount
of the pre-existing secured obligation. In that case, no special protections will
generally be required for the pre-existing secured creditors, as their rights will
not be adversely affected unless circumstances change at a later time (such as
that the value of the encumbered assets begins to diminish) and they will retain
their pre-commencement priority in the encumbered asset, unless they agree
otherwise. Frequently, the only unencumbered assets that may be available for
securing post-commencement finance will be assets recovered through avoid-
ance proceedings. However, providing security on such assets is controversial
under some insolvency laws and is not permitted.
Part two:   II. Treatment of assets on commencement of insolvency proceedings   117


104. Some insolvency laws provide that new lending may be afforded some
level of priority over existing secured creditors, (sometimes referred to as a
“priming lien”). In States where this latter type of priority is permitted, insol-
vency courts recognize the risk to the existing secured creditors and authorize
these types of priority reluctantly and as a last resort. The granting of such a
priority may be subject to certain conditions, such as the provision of notice
to affected secured creditors and the opportunity for them to be heard by the
court; proof by the debtor that it is unable to obtain the necessary finance
without the priority; and the provision of protection for any diminution of the
economic value of encumbered assets, including by a sufficient excess in the
value of the encumbered asset. In some legal systems, all of the priority, super-
priority, security and priming lien options for attracting post-commencement
finance are available to cover the new lending. As a general rule, the economic
value of the rights of pre-existing secured creditors should be protected so that
they will not be harmed. If necessary, this can be achieved, as noted above (see
paras. 63-69), by making periodic payments or providing security rights in
additional assets in substitution for any assets that may be used by the debtor
or encumbered in favour of new lending.


              4.    Authorization for post-commencement finance
105. It may be desirable to link the issue of authorization for new lending to
the damage that may occur or the benefit that is likely to be provided as a
result of the provision of new finance. A number of insolvency laws permit the
insolvency representative (or a debtor-in-possession where that approach is
followed) to determine that new money is required for the continued operation
or survival of the business or the preservation or enhancement of the value of
the estate and obtain unsecured credit without approval by the court or by
creditors. Other laws require approval by the court or creditors in certain
circumstances. Given that new finance may be required on a fairly urgent basis
to ensure the continuity of the business, it is desirable that the number of
authorizations required be kept to a minimum. An insolvency law may take a
hierarchical approach to the authorization required, depending upon the secu-
rity or priority to be provided and the level of credit or finance to be obtained.
Although requiring court involvement may generally assist in promoting trans-
parency and provide additional assurance to lenders, in many instances the
insolvency representative may be in a better position to assess the need for new
finance. Similarly, where secured creditors consent to revised treatment of their
security interests, approval of the court may not be required. In any event, the
court will generally not have access to expertise or information additional to
that provided by the insolvency representative on which to base its decision.

106. The question of providing security over unencumbered assets or assets
that are not fully encumbered is not one that generally should require approval
of the court. Where the insolvency law establishes the level of priority that
generally can be given, for example, an administrative priority, court approval
may not be required. Should court approval be considered desirable, an inter-
mediate approach may be to establish a monetary threshold above which
118                                           UNCITRAL Legislative Guide on Insolvency Law


approval of the court is required. However, where the security or priority to be
given affects the interests, for example, of existing secured creditors and those
secured creditors do not support what is proposed, approval of the court should
be required.

                              5.   Effects of conversion
107. Some insolvency laws provide that any security or priority provided in
respect of new lending can be set aside in a subsequent liquidation, and may
give rise to liability for delaying the commencement of liquidation and poten-
tially damaging the interests of creditors. Such an approach has the potential
to act as a disincentive to commencing reorganization. A more desirable ap-
proach may be to provide that creditors obtaining priority for new funding will
retain that priority in any subsequent liquidation. A further approach provides
that the priority will be recognized in a subsequent liquidation, but will not
necessarily be accorded the same level of and may rank, for example, after
administrative claims relating to the costs of the liquidation or pari passu with
administrative expenses.




                               Recommendations 63-68

      Purpose of legislative provisions

          The purpose of provisions on post-commencement finance is:
           (a) To facilitate finance to be obtained for the continued operation or
      survival of the business of the debtor or the preservation or enhancement of the
      value of the assets of the estate;
          (b) To ensure appropriate protection for the providers of post-commence-
      ment finance; and
          (c) To ensure appropriate protection for those parties whose rights may
      be affected by the provision of post-commencement finance.

      Contents of legislative provisions

      Attracting and authorizing post-commencement finance
      (paras. 94-100, 105 and 106)
           63. The insolvency law should facilitate and provide incentives for post-
      commencement finance to be obtained by the insolvency representative where
      the insolvency representative determines it to be necessary for the continued
      operation or survival of the business of the debtor or the preservation or
      enhancement of the value of the estate. The insolvency law may require the
      court to authorize or creditors to consent to the provision of post-commence-
      ment finance.
Part two:   II. Treatment of assets on commencement of insolvency proceedings                      119




     Priority for post-commencement finance (paras. 101 and 102)
          64. The insolvency law should establish the priority that may be ac-
     corded to post-commencement finance, ensuring at least the payment of the
     post-commencement finance provider ahead of ordinary unsecured creditors,
     including those unsecured creditors with administrative priority.

     Security for post-commencement finance (paras. 103 and 104)
          65. The insolvency law should enable a security interest to be granted for
     repayment of post-commencement finance, including a security interest on an
     unencumbered asset, including an after-acquired asset, or a junior or lower-
     priority security interest on an already encumbered asset of the estate.
          66. The law33 should specify that a security interest over the assets of the
     estate to secure post-commencement finance does not have priority ahead of
     any existing security interest over the same assets unless the insolvency rep-
     resentative obtains the agreement of the existing secured creditor(s) or follows
     the procedure in recommendation 67.
          67. The insolvency law should specify that, where the existing secured
     creditor does not agree, the court may authorize the creation of a security
     interest having priority over pre-existing security interests provided specified
     conditions are satisfied, including:
          (a) The existing secured creditor was given the opportunity to be heard
     by the court;
          (b) The debtor can prove that it cannot obtain the finance in any other
     way; and
          (c) The interests of the existing secured creditor will be protected.34

     Effect of conversion on post-commencement finance (para. 107)
          68. The insolvency law should specify that where reorganization pro-
     ceedings are converted to liquidation, any priority accorded to post-commence-
     ment finance in the reorganization should continue to be recognized in the
     liquidation.35



                              E.     Treatment of contracts
                                       1.    Introduction
108. As an economy develops, more and more of its wealth is likely to be
contained in or controlled by contracts. As a result, the treatment of contracts
is of overriding importance to insolvency proceedings. There are two overall

      33
        This rule may be in a law other than the insolvency law, in which case the insolvency law
should note the existence of the provision.
      34
        See above, paras. 63-69.
      35
        The same order of priority may not necessarily be recognized. For example, post-commence-
ment finance may rank in priority after administrative claims relating to the costs of the liquidation.
120                                       UNCITRAL Legislative Guide on Insolvency Law


difficulties in developing legal policies in that regard. The first difficulty is
that, unlike all other assets of the insolvency estate, contracts are usually tied
to liabilities or claims. That is, it is often the case that the estate must perform
or pay in order to enjoy the rights that are potentially valuable assets. The
result is that difficult decisions must be made about the treatment of a contract
so as to produce the most value for the estate. A second difficulty is that
contracts are of many different types. They include simple contracts for the
sale of goods; short-term or long-term leases of land or of personal property;
and immensely complicated contracts for franchises or for the construction and
operation of major facilities, among many others. Additionally, the debtor
could be involved in the contract as buyer or seller, lessor or lessee, licensor
or licensee, provider or receiver and the problems presented in insolvency may
be very different when viewed from different sides.

109. Achieving the objectives of maximizing the value of the estate and
reducing liabilities and, in reorganization, enabling the debtor to survive and
continue its affairs to the maximum extent possible in an uninterrupted manner
may involve taking advantage of those contracts which are beneficial and
contribute value to the estate (including contracts that will enable the continued
use of crucial property that may be owned by a third party) and rejecting those
which are burdensome or those where the ongoing costs of performance
exceed the benefit to be derived from the contract. As an example, in a contract
where the debtor has agreed to purchase particular goods at a price that is half
the market price at the time of the insolvency, obviously it would be advan-
tageous to the insolvency representative to be able to continue to purchase at
the lower price and sell at the market price. The counterparty would naturally
like to get out of what is now an unprofitable agreement, but to require per-
formance of the contract demands no more of the counterparty than that it
observe the bargain it made prior to insolvency. In many systems it will not
be permitted to escape performance of the contract, although it may be entitled
to an assurance that it will be paid the contract price in full. In many examples,
continuation of the contract will be beneficial to both contracting parties, not
just to the debtor.

110. Deciding how contracts are to be treated in insolvency raises an initial
question of the relative weight to be attached to upholding general contract law
in insolvency on the one hand and the factors justifying interference with those
established contractual principles on the other. Other competing interests may
need to be weighed to ensure that an appropriate balance is achieved between
general public policy goals, the goals of insolvency and predictability in com-
mercial relations. These interests include the relative importance of reorgani-
zation and the participation of secured creditors in insolvency; particular social
concerns raised by some types of contract such as labour contracts (see below,
para. 144, and chapter V, paras. 72 and 73); the effect of permitting inter-
ference with the continuing performance of contracts on the predictability of
commercial and financial relations, and on the cost and availability of credit
(the wider the powers to continue or reject contracts in insolvency, the higher
the cost and the lower the availability of credit is likely to be); as well as the
Part two:   II. Treatment of assets on commencement of insolvency proceedings   121


extent to which the powers to affect the performance of contracts will enhance
the reuse of assets.

111. Where an insolvency law adopts the approach of permitting interference
with the performance of contracts that may be contrary to general contractual
principles, the extent of those powers and the types of contract that can be
affected require careful consideration. It is almost inevitable that, at the com-
mencement of insolvency proceedings, the debtor will be a party to at least one
contract where neither it nor the counterparty have fully performed their
respective obligations, other than the payment of money for goods delivered.
No special rules are required for the situation where only one party has not
fully performed its obligations. If it is the debtor that has not fully performed,
the other party will have a claim for performance or damages, which it can
submit in the insolvency. If it is the counterparty that has not fully performed
its obligations, the insolvency representative can demand performance or dam-
ages from that party. However, where both parties have not fully performed
their obligations, it is a common feature of many insolvency laws that, in
defined circumstances, those contracts may be subject to the stay in a manner
that prevents the counterparty from exercising a right of termination, allowing
performance to continue or the contract to be rejected (or possibly assigned,
although this is not widely permitted). Typically, the insolvency representative
is charged with making this evaluation of how the contract should be treated.
Jurisdictions differ, however, on the question of whether court approval is also
required.

112. In reorganization, where the objective of the proceedings is to enable
the debtor to survive and continue its affairs to the extent possible, the con-
tinuation of contracts that are beneficial or essential to the debtor’s business
and contribute value to the estate may be crucial to the success of the proceed-
ings. These may include contracts for the supply of essential goods and
services or contracts concerning the use of property crucial to the continued
operation of the business, including property owned by third parties. Similarly,
the prospects of success may be enhanced by allowing the insolvency repre-
sentative to reject burdensome contracts, such as those contracts where the cost
of performance is higher than the benefits to be received or, in the case, for
example, of an unexpired lease, the contract rate exceeds the market rate. In
liquidation, the desirability of contracts continuing after commencement of
proceedings is likely to be less important than in reorganization, except where
the contract may add value to the debtor’s business or to a particular asset or
promote the sale of the business as a going concern. A lease agreement, for
example, where the rental is below market price and the remaining term is
substantial, may prove central to any proposed sale of the business or may be
sold to produce value for creditors.

113. As to the types of contract to be affected, a common solution is for
insolvency laws to provide general rules for all kinds of contract and excep-
tions for certain special contracts. The ability to reject labour contracts, for
example, may need to be limited in view of concerns that insolvency can be
used as a means of expressly eliminating the protections that these contracts
122                                       UNCITRAL Legislative Guide on Insolvency Law


afford to employees. Other types of contract requiring special treatment may
include financial contracts (see below, paras. 208-215), contracts for personal
services, where the identity of the party to perform the agreement, whether the
debtor itself or an employee of the debtor, is of particular importance, as well
as contracts for loans and insurance.


      2.   Automatic termination, acceleration or similar clauses
114. Many contracts include a clause that defines events of default giving the
counterparty an unconditional right, for example, of termination or acceleration
of the contract (sometimes referred to as “ipso facto” clauses). These events of
default commonly include the making of an application for commencement, or
commencement, of insolvency proceedings; the appointment of an insolvency
representative; the fact that the debtor satisfies the criteria for commencement
of insolvency proceedings; and even indications that the debtor is in a weak-
ened financial position. Some laws uphold the validity of these types of clause
and where, for example, it is desirable that a contract continue to be performed
after commencement of insolvency proceedings, this will only be possible if
the counterparty does not elect, or can be persuaded not to elect, to exercise
its rights of termination under the contract or if the insolvency law includes a
mechanism that can be used to persuade the counterparty to allow the contract
to continue. In the case of termination clauses, such a mechanism may include
establishing a priority for payment for services provided after the commence-
ment of proceedings (in some insolvency laws this may exist as a general
provision, which typically treats costs incurred after the commencement of
proceedings as a first priority).

115. The approach of upholding these types of clause may be supported by
a number of factors, including the desirability of respecting commercial bar-
gains; the need to prevent the debtor from selectively performing contracts that
are profitable and rejecting others (an advantage that is not available to the
counterparty); the effect on financial contract netting of not upholding an
automatic termination provision; the belief that, since an insolvent business
will generally be unable to pay, delaying the termination of contracts poten-
tially only increases existing levels of debt; the need for creators of intellectual
property to be able to control the use of that property; and the effect on the
counterparty’s business of termination of a contract, especially one with
respect to an intangible.

116. Under a different approach, the insolvency law overrides those clauses,
making them unenforceable. Where the clause provides, for example, for ter-
mination on the occurrence of the defined event, the contract can be continued
over the objection of the counterparty. Although the approach of overriding
such clauses can be regarded as interfering with general principles of contract
law, such interference may be crucial to the success of the proceedings. In
reorganization, for example, where the contract is a critical lease or involves
the use of intellectual property embedded in a key product, continued perform-
ance of the contract may enhance the earnings potential of the business; reduce
Part two:   II. Treatment of assets on commencement of insolvency proceedings   123


the bargaining power of an essential supplier; capture the value of the debtor’s
contracts for the benefit of all creditors; and assist in locking all creditors into
a reorganization.

117. In liquidation, the arguments in favour of overriding termination clauses
include the need to keep the business together to maximize its sale value or to
enhance its earnings potential; to capture the value of the contract for the
benefit of all creditors rather than forfeiting it to the counterparty; and the
desirability of locking all parties into the final disposal of the business.

118. Although some insolvency laws do permit these types of clause to be
overridden if insolvency proceedings are commenced, this approach has not
yet become a general feature of insolvency laws. There is an inherent tension
between promoting the debtor’s survival, which may require the preservation
of contracts, and injecting unpredictability and extra cost into commercial
dealings by creating a variety of exceptions to general contract rules. While
this issue is clearly one that may require a careful weighing of the advantages
and disadvantages, there are, nevertheless, circumstances where the ability of
the insolvency representative to ensure that a contract continues to be per-
formed will be crucial to the success of reorganization and also, but perhaps
to a lesser extent, liquidation where the business is to be sold as a going
concern. For these reasons, it is desirable that an insolvency law permit such
clauses to be overridden. Any negative impact of a policy of overriding these
types of clauses can be balanced by providing compensation to creditors who
can demonstrate that they have suffered damage or loss as a result of the
contract continuing to be performed after commencement of insolvency pro-
ceedings, or including exceptions to a general override of these clauses for
certain types of contracts, such as contracts to lend money and, in particular,
financial contracts (see below, paras. 208-215).

119. Where an insolvency law provides that termination clauses can be over-
ridden, creditors may be tempted to take pre-emptive action to avoid that
outcome by terminating the contract on some other ground before the applica-
tion for insolvency proceedings is made (assuming a default by the debtor
other than one triggered by commencement of the proceedings). Such a result
may be mitigated by providing that the insolvency representative has the power
to reinstate those contracts, provided both pre- and post-commencement
obligations are fulfilled.

                   3.    Continuation or rejection of contracts
(a)   Procedure for continuation or rejection of contracts
120. Insolvency laws adopt different approaches to continuation and rejec-
tion of contracts. Under some laws, contracts are unaffected by the commence-
ment of insolvency proceedings so that contractual obligations remain binding
and the general rules of contract law will continue to apply unless an insol-
vency law expressly provides different rules, such as an express power to
override automatic termination clauses or to reject a contract.
124                                      UNCITRAL Legislative Guide on Insolvency Law


121. Other laws link continuation and rejection in a common procedure that
requires the insolvency representative to take some positive action with respect
to a contract, such as providing notice to the counterparty that the contract is
to continue to be performed (and in some cases be adopted by the insolvency
estate) or be rejected. Under laws that adopt this approach, the stay would
apply to the counterparty’s right to terminate, allowing the insolvency repre-
sentative time to consider what action should be taken with respect to the
contract. One disadvantage of the approach of requiring the insolvency repre-
sentative to take positive action on all contracts is that in practice there may
be many cases where no decision can be taken because the contract cannot be
performed. To require an explicit choice to be made on every contract could
also be excessively costly and cumbersome. A further difficulty associated
with this approach relates to whether or not the insolvency representative is
well informed of all contracts to which the debtor is a party and is therefore
in a position to take action with respect to each one. The manner in which the
law deals with contracts of which the insolvency representative is not aware,
in particular in terms of default rules, is therefore important.

  (i)   Specifying time periods
122. Some laws requiring a positive action by the insolvency representative
also require that action to be taken within a specified period of time (with
perhaps provision for extension in certain circumstances), which would gener-
ally be longer in reorganization than in liquidation. Examples of specific time
periods vary from 28 to 60 days. Other laws provide for the time period to be
determined by the court. This approach is aimed at ensuring certainty for both
parties. It requires the insolvency representative to take timely action with
respect to contracts outstanding at the time of commencement and offers the
counterparty some certainty as to the continued performance of the contract
within a reasonable period after commencement of proceedings.

  (ii) Default rules
123. A number of laws adopt a default rule to the effect that failure of the
insolvency representative to act within the specified time results in the contract
being treated, for example, as rejected or unenforceable. Where a default rule
is adopted, a distinction between liquidation and reorganization might be
made, as well as a distinction between those contracts of which the insolvency
representative is aware and those of which it is not aware. In liquidation, since
it may be reasonable to assume that the failure of the insolvency representative
to take a decision with respect to a contract would most likely imply a decision
to reject, contracts could be automatically rejected unless action is taken to
preserve a contract. That result would be consistent with the goal of liquidation
where it requires piecemeal sale of the assets.

124. The same assumption may not always be appropriate in reorganization
or sale of the business as a going concern and more flexibility might be
required to avoid a situation where the failure to take a timely decision
deprives the estate of a contract that might be crucial for the proceedings.
Part two:   II. Treatment of assets on commencement of insolvency proceedings   125


Accordingly, it may be appropriate to allow the insolvency representative to
make a decision as to rejection up to the time of approval of the reorganization
plan, provided that the performance costs of the contract up to the time of
rejection are paid as an administrative expense and that the counterparty has
the ability to compel an earlier decision where it is required or desired. It is
desirable that treatment of specific contracts is addressed clearly in the plan,
with perhaps a provision that contracts not so addressed should be treated as
automatically rejected on approval of the plan.

   (iii) Right of the counterparty to request a decision
125. Some laws provide that the counterparty has an unconditional right to
request the insolvency representative to make a decision on a particular con-
tract within a specified period of time. Such a rule may apply even where the
insolvency law specifies a time limit for the insolvency representative to make
a decision, as it will enable the counterparty to seek a decision without having
to wait for the time limit to expire. This may be of particular importance where
the contract in question involves provision of an ongoing service and the
failure of the insolvency representative to act may lead to the accrual of
unnecessary expense (e.g. rent for property that is leased by the debtor can be a
significant administrative cost if a lease is not promptly terminated) or to the
termination of an essential service. Where the insolvency representative fails to
decide within the specified time period, the insolvency law may either permit
the counterparty to apply to the court to require a decision to be made or apply
a default rule that the contract be treated either as continued or rejected.

   (iv) Continuation and rejection of contracts as a whole
126. Whatever rules are adopted with respect to continuing performance or
rejection of contracts, it is desirable that any powers of the insolvency repre-
sentative should be limited to the contract as a whole, thus avoiding a situation
where the insolvency representative could choose to continue performing
certain parts of a contract and reject others.

   (v) Contracts known to the insolvency representative
127. It is also desirable that the insolvency representative’s power with
respect to contracts is limited to those contracts which are known to it or the
court (where the insolvency law requires the court to make determinations with
respect to contracts). If this limitation is not adopted, the consequences of
failure to take a decision with respect to a contract of which the insolvency
representative has no knowledge might be a claim for damages and possible
professional liability. Where the insolvency representative is not aware of a
particular contract, it also may be undesirable for the law to apply a default
rule that will lead to continued performance or rejection before the insolvency
representative has had the opportunity to assess the contract. One solution to
this issue (to the extent that the debtor complies) would be to include in the
law a requirement for the debtor to provide to the insolvency representative a
list of contracts that have not been fully performed (see chap. III, para. 24).
126                                       UNCITRAL Legislative Guide on Insolvency Law


(b)   Timing and notice of continuation and rejection
128. Where the law permits the insolvency representative to reject a contract,
it will be desirable to establish the time from which the rejection will be
effective, whether from the time of making the decision or retroactively. One
approach is to make rejection retroactive to the time the application for com-
mencement of proceedings is made, with the result that no post-application
liability will arise under a contract, except in respect of post-application goods
or services supplied to the benefit of the estate.

129. Where the law requires the insolvency representative to take a decision
as to continuation or rejection of a contract, it is desirable that it also include
a requirement that the counterparty or counterparties be notified of that deci-
sion. The notice should inform the counterparty of its rights, including the right
to challenge the insolvency representative’s decision with respect to the
contract and to submit a claim in the insolvency (either with respect to a pre-
commencement default or arising from the decision on the contract) and any
related formalities.

(c)   Continuation of contracts where the debtor is in breach
130. Where the debtor is in breach under a contract at the time the applica-
tion for insolvency is made, there is a policy issue of whether it is fair to
require the counterparty to continue to deal with an insolvent debtor in such
circumstances. As a condition of continuing the performance of such a contract
for the remainder of the contract term, some insolvency laws require the insol-
vency representative to cure any breach by the debtor under the contract
(returning the counterparty to the economic position it was in before the breach
occurred) and guarantee future performance by providing, for example, a bond
or guarantee. Other insolvency laws do not require past breaches to be cured,
but may impose restrictions as to the circumstances in which performance can
be continued. One example is contracts that can be divided into severable
units, such as contracts for the supply of utilities, which are billed on a
monthly basis. Insolvency laws often specifically allow the continuation of
such contracts for the provision of essential services, such as telephone, elec-
tricity, gas, water and waste collection. There is some justification for assuring
the debtor continuing access to these services without requiring cure of the
breach (especially in the case of a creditor application for commencement),
provided it can perform its post-commencement obligations. An insolvency
law should clearly address the circumstances in which the debtor is required
to cure a breach in order for the contract to be continued. Some insolvency
laws also require the insolvency representative to guarantee future performance
and, in some cases, accept personal liability in the event of future breach.

(d)   Performance prior to continuation or rejection
131. Although it is not common for insolvency laws to do so, it may also be
desirable to address the question of the obligations of the counterparty in the
period between commencement of proceedings and a decision as to treatment
Part two:   II. Treatment of assets on commencement of insolvency proceedings     127


of a contract (in those cases where such a decision is required), in particular
whether the counterparty is required to commence or continue its performance.
Such an approach would satisfy objectives of certainty and predictability for
all parties concerned. Where a contract continues to be performed prior to a
determination to continue or reject that contract, the costs of continued per-
formance arising under the contract should be payable as an administrative
expense. The rationale for such an approach is that it is fair to assume that
post-commencement performance of a contract is of benefit to the estate,
otherwise it should have been rejected. If the insolvency representative uses
third-party-owned assets that are in the possession of the debtor subject to
contract, the costs under the contract of continued performance of the contract
should be payable as an administrative expense, and the third party should be
protected against diminution of the value of those assets, to the extent that that
issue is not covered by the contract.

(e)     Effect of continuation or rejection on the counterparty

      (i) Continuation
132. Under those laws which require a positive action by the insolvency
representative, contracts that the insolvency representative elects to continue to
perform are treated as ongoing post-commencement obligations of the debtor
that must be performed both by the estate and the counterparty. Claims arising
from performance of those contracts are treated in a number of insolvency laws
as an administrative expense (not as an unsecured claim) and given priority in
distribution. Since the granting of such a priority constitutes a potential risk for
other creditors (who will be paid after the priority creditors), it is desirable that,
if this approach is followed, only contracts that will be profitable or essential
to the continued operation of the debtor continue after commencement of
insolvency proceedings. In those jurisdictions where the general rules of con-
tract law will apply and no decision as to continuation is required from the
insolvency representative, the insolvency law may provide that such claims
will have no priority and be ranked with other unsecured claims.

133. Since continuation of a contract with a party subject to insolvency
proceedings may involve an element of risk for the counterparty that would not
otherwise have arisen, such as non-payment, it may be appropriate for the
insolvency law to consider whether certain measures of protection should be
afforded the counterparty. A number of factors will need to be weighed,
including the importance of the contract to the proceedings; the cost to the
proceedings of providing the necessary protections; whether the debtor or the
estate will be able to perform the obligations under the continued contract; and
the impact on commercial contracting of forcing the counterparty to assume
the risk of non-payment. If the contract provides, for example, for the seller to
extend credit to the debtor for a certain period of time before requiring pay-
ment or provides for payment on delivery, the seller may incur substantial
costs and suffer harm if, by the time of the payment or the delivery, the
insolvency representative is no longer able to pay. Some laws address these
issues by requiring the insolvency representative to guarantee payment or
128                                                    UNCITRAL Legislative Guide on Insolvency Law


performance to the counterparty, such as through a bank guarantee or letter of
credit. Under other laws, the insolvency representative may be personally li-
able for performance. This approach may discourage continuation of contracts
where there is some risk of a failure of performance and thus have a negative
affect on reorganization. Personal liability may be particularly onerous in the
case of contracts such as labour contracts. Under a further approach, the
counterparty is required to assume the risk of non-payment on the basis that
that risk is a usual risk of commercial dealings. Providing an administrative
priority for claims and payments relating to post-commencement performance
under a continued contract may afford a measure of protection to the
counterparty (although it may be limited if assets available for the payment of
such expenses are limited).

      (ii)     Rejection
134. Where a contract is rejected, the counterparty is generally excused from
performing the remainder of the contract and the principal issue to be deter-
mined is the remedies that will be available to the counterparty. Many laws
provide that the counterparty is only entitled to a remedy in damages, even if
other remedies would have been available outside of insolvency. One of the
reasons for this approach is that allowing other remedies, such as delivery of
goods manufactured but not delivered prior to commencement of insolvency
proceedings, would amount to paying the full claim of the counterparty, a
result not available to other unsecured creditors and one that represents a
departure from the principle of equal treatment. Some laws, however, do per-
mit such a remedy in respect of the delivery of goods, while other laws permit
performance in the case of contracts for the sale of land.

135. Where the remedy is one of damages, calculation of the unsecured
damages that result from the rejection might be determined in accordance with
applicable law other than the insolvency law and the counterparty becomes an
unsecured creditor with a claim equal to the determined amount. In addition to
damages resulting from the rejection, the counterparty may have a claim with
respect to performance of the contract in the period before rejection (which
may rank as an administrative claim).36

(f)     Amendment of continuing contracts
136. A further issue to be considered in respect of continued contracts is the
circumstances in which an insolvency representative may alter the terms and
conditions of those contracts. As noted above, the terms and conditions of the
contract as a whole must be respected and, as a general principle, the insol-
vency representative will have no greater rights in respect of amendment of the
contract than the debtor itself would normally have under the contract. The
insolvency representative would generally be required to negotiate any amend-
ment with the counterparty and any modification without the consent of that


        36
             See chap. V, paras. 62-79, on ranking of claims.
Part two:   II. Treatment of assets on commencement of insolvency proceedings   129


other party will constitute a breach of contract for which the counterparty may
seek applicable remedies.

                         4.    Leases of land and premises
137. Some insolvency laws include specific provisions on unexpired leases
of land and premises, distinguishing between residential and commercial
leases. Commercial leases in particular are often of significance in reorganiza-
tion cases. For example, leases at below market price represent an asset that
might be sold and return a benefit to the estate. In contrast, the ability to escape
a lease of a money-losing location may be an advantage where the debtor
needs to reduce the size of its business to ensure the success of reorganization.

138. Under some laws, a lease of which the debtor is the lessee can be
rejected without reference to the expiry date, provided the notice periods in the
law or the lease are observed. Rejection would give rise to a claim by the lessor
for compensation for premature termination. Where the debtor is a lessee and
its lease is to continue, it may be appropriate for certain conditions to be
imposed on the insolvency estate, such as that the insolvency representative
must cure any default, provide compensation for any harm arising from such
a default and provide assurance as to future performance under the lease. It
may also be desirable to set a ceiling on damages claimed by the lessor (which
may be a monetary amount or a specified period of time in respect of which
damages may be payable) so that the claim under a long-term lease does not
overwhelm the claims of other creditors. Lessors will ordinarily have the
opportunity to mitigate losses by re-letting the property.

                                     5.    Assignment
139. The ability of the insolvency representative to elect to assign a contract
notwithstanding insolvency-triggered termination provisions or restrictions on
transfer contained in the contract can have significant benefits to the estate and
therefore to the beneficiaries of the proceeds of distribution following liquida-
tion or as part of a reorganization. There may be circumstances, such as where
the contract price is lower than the market value, where rejection of the con-
tract may result in a windfall for the counterparty. If the contract can be
assigned, the insolvency estate, rather than the counterparty, will benefit from
the difference between the contract and market prices.

140. However, providing for assignment of a contract against the terms of
the contract may undermine the contractual rights of the counterparty and raise
issues of prejudice, especially where the counterparty has little or no say in the
selection of the assignee. It may be undesirable to compel the transfer of a
contract to a transferee who may not be known to the counterparty or with
whom the counterparty may not wish to do business. Different approaches are
taken to the issue of assignment. Some insolvency laws specify that non-
assignment clauses are made null and void by the commencement of insol-
vency proceedings. Other insolvency laws leave the matter to general contract
130                                                UNCITRAL Legislative Guide on Insolvency Law


law; if the contract contains a non-assignment clause then the contract cannot
be assigned unless the counterparty or all parties to the original contract agree.
Some of these laws also provide, however, that if the counterparty does not
consent to assignment, the court may approve the assignment if, for example,
it can be shown that the counterparty is withholding consent unreasonably; the
counterparty will not be substantially disadvantaged by the assignment; or the
insolvency representative can demonstrate to the counterparty that the assignee
can adequately perform the contract.37
141. Where an insolvency law allows assignment of contracts, it would be
highly desirable to also require the debtor to cure any breach prior to the
assignment of a contract. This would help ensure a successful, problem-free
substitution of the assignee for the debtor as the contracting party.
142. Irrespective of the powers of the insolvency representative to assign
contracts, some contracts cannot be assigned because they require the perform-
ance of irreplaceable personal services or because assignment is prohibited by
the operation of law. Some States, for example, prohibit the assignment of
government procurement contracts.

      6.   General exceptions to the power to continue performance,
                        reject or assign contracts
143. Exceptions to the powers of the insolvency representative with respect
to treatment of contracts generally fall into two categories. The first relates to
specific types of contract, the second to contracts that cannot be performed. In
respect of the first, where the insolvency law provides that automatic termina-
tion provisions are overridden, specific exceptions may be desirable for con-
tracts, such as short-term financial contracts (e.g. swap and futures contracts—
see below, paras. 208-215), insurance contracts and contracts for the making
of a loan. Exceptions to the power to reject may also be appropriate in the case
of labour agreements, agreements where the debtor is a lessor or franchisor or
a licensor of intellectual property and termination of the agreement would end
or seriously affect the business of the counterparty, in particular where the
advantage to the debtor may be relatively minor, and contracts with govern-
ment, such as licensing agreements and procurement contracts.
144. To enhance the transparency of the insolvency regime, it is desirable
that the limitations on the powers of the insolvency representative to deal with
the types of contract discussed in this section are stated clearly in the insol-
vency law.

(a)    Labour contracts
145. As noted above, one important exception to the powers discussed in this
section is that of labour contracts. These contracts are important not only in

      37
         This approach is consistent, for example, with the approach taken in the United Nations
Convention on the Assignment of Receivables in International Trade, article 9 (for the text of art. 9,
see above, footnote 31).
Part two:   II. Treatment of assets on commencement of insolvency proceedings   131


reorganization, but also in liquidation where the insolvency representative is
attempting to sell the debtor’s business as a going concern. A higher price may
be obtained if the insolvency representative is able to terminate onerous labour
contracts to achieve necessary reduction of the labour force of the debtor.
However, the relationship between employee and employer raises some of the
most difficult questions in insolvency law. It is not simply the contract itself,
which in essence is a pending contract like any other contract, but also the
usually mandatory provisions of other laws that protect the position of
employees. These may relate, for example, to unfair dismissal; minimum rates
of pay; paid leave; maximum work periods; maternity leave; equal treatment;
and non-discrimination. The difficult question is generally the extent to which
these provisions will have an impact on the insolvency, raising issues that
are much broader than termination of the contract and priority of monetary
claims in respect of unpaid wages and benefits. For these reasons, a number
of States have adopted special regimes to deal with the protection of em-
ployees’ claims in insolvency (see chap. V, paras. 72 and 73, on priority of
employee claims) and, in order to avoid insolvency proceedings being used as
a means of eliminating employee protection, these laws specifically limit
the insolvency representative’s ability to reject labour contracts. This
approach may include limiting the use of the powers to certain specified
circumstances, for example, where the employee’s remuneration is excessive
compared with what the average employee would receive for the same work.
In some States the law provides for employees to follow the business in case
of sale as a going concern in both liquidation and reorganization, in others only
in reorganization.


(b)   Contracts for irreplaceable and personal services
146. The second category relates to those contracts where, irrespective of
how an insolvency law treats automatic termination provisions, the contract
cannot continue because it provides for performance by the debtor or an
employee of the debtor of irreplaceable personal services (the contract may
involve, for example, particular intellectual property, services involving a
partnership agreement or provision of services by a person with highly specia-
lized skills or by a named person with a particular skill).


                         7.   Post-commencement contracts
147. A further category of contracts in insolvency, in addition to contracts
that are not fully performed, is contracts entered into after the proceedings
have commenced. In reorganization and where the business is to be sold as a
going concern in liquidation, there is often a need to enter into contracts (both
in the ordinary course of business and otherwise) to maintain the business as
a going concern and enable it to continue earning for the ultimate benefit of
creditors. These contracts are generally regarded as post-commencement
obligations of the estate and costs and expenses incurred in their performance
are paid in full as an expense of the insolvency administration.
132                                               UNCITRAL Legislative Guide on Insolvency Law




                                 Recommendations 69-86

      Purpose of legislative provisions

          The purpose of provisions on treatment of contracts is:
           (a) To establish the manner in which contracts, under which both the
      debtor and its counterparty have not yet fully performed their respective
      obligations, should be addressed in the insolvency law, including the relation-
      ship between the insolvency law and applicable law, with the objective of
      maximizing the value and reducing the liabilities of the estate;
           (b) To define the scope of the powers to deal with these contracts and the
      situations in which and by whom these powers may be exercised;
          (c) To identify the types of contract that should be excepted from the
      exercise of these powers; and
          (d) To identify the kinds of protection that will be available to
      counterparties to continued contracts.

      Contents of legislative provisions
      Treatment of contracts not fully performed (paras. 108-112)

           69. The insolvency law should specify the treatment of contracts under
      which both the debtor and its counterparty have not yet fully performed their
      respective obligations.

      Automatic termination and acceleration clauses (paras. 114-119)

           70. The insolvency law should specify that any contract clause that
      automatically terminates or accelerates a contract upon the occurrence of any
      of the following events is unenforceable as against the insolvency representa-
      tive and the debtor:
          (a) An application for commencement, or commencement, of insolvency
      proceedings;
          (b) The appointment of an insolvency representative.38

           71. The insolvency law should specify the contracts that are exempt from
      the operation of recommendation 70, such as financial contracts, or subject to
      special rules, such as labour contracts.

      Continuation or rejection (paras. 120-122, 126 and 127)

         72. The insolvency law should specify that the insolvency representative
      may decide to continue the performance of a contract of which it is aware


       38
         This recommendation would apply only to those contracts where such clauses could be over-
ridden (see commentary above, paras. 143-145, on exceptions) and is not intended to be exclusive,
but to establish a minimum: the court should be able to examine other contractual clauses that would
have the effect of terminating a contract on the occurrence of similar events.
Part two:    II. Treatment of assets on commencement of insolvency proceedings                       133




     where continuation would be beneficial to the insolvency estate.39 The insol-
     vency law should specify that:
            (a) The right to continue applies to the contract as a whole; and
         (b) The effect of continuation is that all terms of the contract are
     enforceable.

          73. The insolvency law may permit the insolvency representative to
     decide to reject a contract.40 The insolvency law should specify that the right
     to reject applies to the contract as a whole.

     Timing and notice of decision to continue or reject (paras. 128 and 129)

          74. The insolvency law should specify a time period within which the
     insolvency representative is required to make a decision to continue or reject
     a contract, which time period may be extended by the court.

          75. The insolvency law should specify the time at which the rejection
     will be effective.

          76. The insolvency law should specify that where a contract is continued
     or rejected, the counterparty is to be given notice of the continuation or rejec-
     tion, including its rights with respect to submitting a claim and the time in
     which the claim should be submitted, and permit the counterparty to be heard
     by the court.

     Right of the counterparty to request a decision (para. 125)

          77. Notwithstanding recommendation 74, the insolvency law should
     permit a counterparty to request the insolvency representative (within any
     specified time limit) to make a prompt decision and, in the event that the
     insolvency representative fails to act, to request the court to direct the insol-
     vency representative to make a decision to continue or reject a contract.

     Consequences of failure to make a decision (paras. 123, 124 and 127)

          78. The insolvency law should specify the consequences of the failure of
     the insolvency representative to make a decision within the specified time
     period with respect to contracts of which it is aware. Failure by the insolvency
     representative to act within the specified time period should not operate to
     continue a contract of which the insolvency representative was not aware.41


       39
         Provided the automatic stay on commencement of proceedings applies to prevent termination
(pursuant to an automatic termination clause) of contracts with the debtor, all contracts should remain
in place to enable the insolvency representative to consider the possibility of continuation, unless the
contract has a termination date that happens to fall after the commencement of insolvency proceedings.
       40
         An alternative to providing a power to reject contracts is the approach of those jurisdictions
which provide that performance of a contract simply ceases unless the insolvency representative
decides to continue its performance.
       41
         See chap. III, para. 24, which refers to the debtor’s obligation to provide information, includ-
ing a list of contracts not fully performed.
134                                           UNCITRAL Legislative Guide on Insolvency Law




      Recommendations 69-86 (continued)

      Continuation of contracts where the debtor is in breach (para. 130)

           79. The insolvency law should specify that where the debtor is in breach
      of a contract the insolvency representative can continue the performance of
      that contract, provided the breach is cured, the non-breaching counterparty is
      substantially returned to the economic position it was in before the breach and
      the estate is able to perform under the continued contract.

      Performance prior to continuation or rejection (para. 131)

            80. The insolvency law should specify that the insolvency representative
      may accept or require performance from the counterparty to a contract prior to
      continuation or rejection of the contract. Claims of the counterparty arising
      from performance accepted or required by the insolvency representative prior
      to continuation or rejection of the contract should be payable as an adminis-
      trative expense:
          (a) If the counterparty has performed the contract the amount of the
      administrative expense should be the contractual price of the performance; or
           (b) If the insolvency representative uses assets owned by a third party
      that are in the possession of the debtor subject to contract, that party should
      be protected against diminution of the value of those assets and have an
      administrative claim in accordance with subparagraph (a).

      Damages for subsequent breach of a continued contract (paras. 132 and 133)

           81. The insolvency law should specify that where a decision is made to
      continue performance of a contract, damages for the subsequent breach of that
      contract should be payable as an administrative expense.

      Damages arising from rejection (paras. 134 and 135)

           82. The insolvency law should specify that any damages arising from the
      rejection of a pre-commencement contract would be determined in accordance
      with applicable law and should be treated as an ordinary unsecured claim. The
      insolvency law may limit claims relating to the rejection of a long-term
      contract.

      Assignment of contracts (paras. 139-142)

          83. The insolvency law may specify that the insolvency representative
      can decide to assign a contract, notwithstanding restrictions in the contract,
      provided the assignment would be beneficial to the estate.

          84. Where the counterparty objects to assignment of a contract, the insol-
      vency law may permit the court to nonetheless approve the assignment
      provided:
          (a) The insolvency representative continues the contract;
Part two:    II. Treatment of assets on commencement of insolvency proceedings       135




            (b) The assignee can perform the assigned contractual obligations;
         (c) The counterparty is not substantially disadvantaged by the assign-
     ment; and
            (d) The debtor’s breach under the contract is cured before assignment.

          85. The insolvency law may specify that, where the contract is assigned,
     the assignee will be substituted for the debtor as the contracting party with
     effect from the date of the assignment and the estate will have no further
     liability under the contract.

     Post-commencement contracts (para. 147)

          86. The insolvency law should specify that contracts entered into after
     the commencement of insolvency proceedings are post-commencement obliga-
     tions of the estate. Claims arising from those contracts should be payable as
     an administrative expense.




                             F.    Avoidance proceedings
                                      1.   Introduction
148. Insolvency proceedings (both liquidation and reorganization) may com-
mence long after a debtor first becomes aware that such an outcome cannot be
avoided. In that intervening period, there may be significant opportunities for
the debtor to attempt to hide assets from creditors, incur artificial liabilities,
make donations or gifts to relatives and friends or pay certain creditors to the
exclusion of others. There may also be opportunities for creditors to initiate
strategic action to place themselves in an advantageous position. The result of
such activities, in terms of the eventual insolvency proceedings, generally
disadvantages ordinary unsecured creditors who were not party to such actions
and do not have the protection of a security interest.

149. The use of the word “transaction” in this section is intended to refer
generally to the wide range of legal acts by which assets may be disposed of
or obligations incurred, including by way of transfer, payment, encumbrance,
guarantee, loan or release, and may include a composite series of such trans-
actions.

150. Many insolvency laws include provisions that apply retroactively from
a particular date (such as the date of application for, or commencement of,
insolvency proceedings) for a specified period of time (often referred to as the
“suspect” period) and are designed to overturn those past transactions to which
the insolvent debtor was a party or which involved the debtor’s assets where
they have certain effects. These effects include reducing the net worth of the
debtor (e.g. by gifting of its assets or transferring or selling assets for less than
136                                       UNCITRAL Legislative Guide on Insolvency Law


their fair commercial value); or upsetting the principle of equal sharing
between creditors of the same rank (e.g. by payment of a debt to a particular
unsecured creditor or granting a security interest to a creditor who is otherwise
unsecured when other unsecured creditors remain unpaid and unsecured).
Many non-insolvency laws also address these types of transaction as being
detrimental to creditors outside insolvency. In some cases, the insolvency rep-
resentative will be able to use those non-insolvency laws in addition to the
provisions of the insolvency law.
151. It is a generally accepted principle of insolvency law that collective
action is more efficient in maximizing the assets available to creditors than a
system that leaves creditors free to pursue their individual remedies and that
it requires all like creditors to receive the same treatment. Provisions dealing
with avoidance powers are designed to support these collective goals, ensuring
that creditors receive a fair allocation of an insolvent debtor’s assets consistent
with established priorities and preserving the integrity of the insolvency estate.
Avoidance provisions may also have a deterrent effect, discouraging creditors
from pursuing individual remedies in the period leading up to insolvency if
they know that these may be reversed or their effects nullified on commence-
ment. Transactions are typically made avoidable in insolvency to prevent fraud
(e.g. transactions designed to hide assets for the later benefit of the debtor or
to benefit the officers, owners or directors of the debtor); to uphold the general
enforcement of creditors’ rights; to ensure equitable treatment of all creditors
by preventing favouritism where the debtor wishes to advantage certain credi-
tors at the expense of the rest; to prevent a sudden loss of value from the
business entity just before the supervision of the insolvency proceedings is
imposed; and, in some States, to create a framework for encouraging out-of-
court settlement—creditors will know that last-minute transactions or seizures
of assets can be set aside and therefore will be more likely to work with
debtors to arrive at workable settlements without court intervention.
152. Avoidance provisions can be important to an insolvency law not only
because the policy upon which they are based is sound, but also because they
may result in recovery of assets or their value for the benefit of creditors
generally and because provisions of this nature help to create a code of fair
commercial conduct that is part of appropriate standards for the governance of
commercial entities. It should be noted that, in the cross-border context, juris-
dictions with insolvency laws that do not provide for avoidance of certain
types of transaction, may encounter difficulties with recognition of proceed-
ings and cooperation with courts and insolvency officials of jurisdictions
where those transactions are subject to avoidance.
153. Notwithstanding the generally accepted rationale of avoidance provi-
sions, it is important to bear in mind that many of the transactions that may be
subject to avoidance in insolvency are perfectly normal and acceptable when
they occur outside that context, but become suspect only when they occur in
proximity to the commencement of insolvency proceedings. Avoidance powers
are not intended to replace or otherwise affect other devices for the protection
of the interests of creditors that would be available under general civil or
commercial law.
Part two:   II. Treatment of assets on commencement of insolvency proceedings   137


154. Avoidance rules are much discussed, principally as to their effective-
ness in practice and the somewhat arbitrary rules that are necessary to define,
for example, relevant time periods and the types of transaction that may be
avoided. As is the case with a number of the core provisions of an insolvency
law, the design of avoidance provisions requires a balance to be reached
between competing social benefits such as, on the one hand, the need for
strong powers to maximize the value of the estate for the benefit of all creditors
and, on the other, the possible undermining of contractual predictability and
certainty. It may also require a balance to be reached between avoidance
criteria that are easily proven and will result in a number of transactions being
avoided and narrower avoidance criteria that are difficult to prove but more
restricted in the number of transactions that will be avoided successfully. To
minimize the potentially negative effects of avoidance powers on contractual
predictability and certainty, it is desirable that as far as possible the categories
of transactions to be avoidable (irrespective of whether they are broadly or
narrowly defined) and the exercise of avoidance powers be subject to clear
criteria that will enable business and commercial risks to be ascertained.

155. The decision whether or not to commence avoidance proceedings with
respect to a particular transaction requires a number of different considerations
to be weighed. In the case of actions to restore assets to the insolvency estate,
these considerations will include whether avoidance of the transaction will be
beneficial to the estate (such as where the taking of an avoidance action may
disrupt reorganization proposals, especially where the action can be taken by
creditors without the consent of the insolvency representative); the likely cost
of avoidance proceedings to the estate; the likelihood of recovering value for
the estate; possible delays in recovery; and the difficulties associated with
proving the elements necessary to avoid a particular transaction.


                                2.    Avoidance criteria
156. Approaches to establishing the criteria for avoidance actions vary con-
siderably between insolvency laws both in terms of specific criteria and the
manner in which they are combined in each law. In terms of the specific
criteria, they can be grouped broadly as objective and subjective criteria.

(a)   Objective criteria
157. One approach emphasizes the reliance on generalized, objective criteria
for determining whether transactions are avoidable. The question would be, for
example, whether the transaction took place within the suspect period or
whether the transaction evidenced any of a number of general characteristics set
forth in the law (e.g. whether appropriate value was given for the assets trans-
ferred or the obligation incurred, whether the debt was mature or the obligation
due or whether there was a special relationship between the parties to the
transaction). While such generalized criteria may be easier to apply than criteria
that rely upon proof, for example, of intent, they can also have arbitrary results
if relied upon exclusively. So, for example, legitimate and useful transactions
138                                      UNCITRAL Legislative Guide on Insolvency Law


that fall within the specified suspect period might be avoided, while fraudulent
or preferential transactions that fall outside the period are protected.

(b)   Subjective criteria
158. Another approach emphasizes case-specific, subjective criteria such as
whether there is evidence of intention to hide assets from creditors, whether the
debtor was insolvent when the transaction took place or became insolvent as
a result of the transaction, whether the transaction was unfair in relation to
certain creditors and whether the counterparty knew that the debtor was insol-
vent at the time the transaction took place or would become insolvent as a
result of the transaction. This individualized approach may require detailed
consideration of the intent of the parties to the transaction and of other factors
such as the debtor’s financial circumstances at the time the transaction
occurred, the financial effect of the transaction on the debtor’s assets and what
might constitute the normal course of business between the debtor and particu-
lar creditors.

(c)   Combining the elements
159. Very few insolvency laws rely solely on subjective criteria as the basis
of avoidance provisions; they are generally combined with time periods within
which the transactions must have occurred. In some States, a heavy reliance
upon subjective criteria has led to considerable litigation and the imposition of
extensive costs on insolvency estates. In order to avoid these costs, some laws
have recently adopted a strictly objective approach of a short suspect period,
such as three to four months, which in some cases is combined with an arbi-
trary rule that all transactions occurring within that period would be suspect
unless there was a roughly contemporaneous exchange of value between the
parties to the transaction. Additionally, the short suspect period may be used
to create a presumption of necessary intent or knowledge, especially of insol-
vency, on the part of the debtor or the counterparty to the transaction or both,
which may be rebutted by appropriate evidence.

160. Some laws adopt a two-tiered approach combining the short period
within which all transactions are avoided and no defences are available to
creditors, with a longer period in which certain additional elements have to be
proven. The law may specify that a certain type of transaction occurring
within, for example, a six-month period before commencement, is avoided
without requiring the insolvency representative to show anything other than
that it is a transaction as defined for the purposes of the legislation and that it
occurred within the time limit. No defences are available to the counterparty.
For transactions occurring within, for example, a one-year period, the insol-
vency representative is required to show that the transaction was not in the
ordinary course of business and that it had a certain effect, for example, the
creation of a preference. To defeat the claim the counterparty must show that
it has a relevant defence. As with subjective criteria, however, too great a
reliance on objective criteria can also produce negative outcomes. Experience
in several States has shown that where certain types of transaction are
Part two:   II. Treatment of assets on commencement of insolvency proceedings   139


automatically or easily avoided under the insolvency law, insolvency repre-
sentatives can avoid each transaction occurring within a suspect period without
any individual analysis or calculation of the potential cost or benefit of
recovery for creditors generally. Furthermore, such an approach may result in
the avoidance of essentially “fair” commercial transactions and impose the
burden and expense of challenging avoidance actions on individual creditors.

161. A number of insolvency laws also combine these different approaches
to address different types of transaction. For example, preferential transactions
and undervalued transactions may be defined by reference to objective criteria,
while transactions aimed at defeating or hindering creditors will be defined by
reference to questions of the intent of both the debtor and the counterparty.
One insolvency law that adopts a combination of those elements provides, for
example, that transactions such as gifts, granting of a security interest for
existing debts and extraordinary payments (those which have not been made
with the usual means of payment or before the due time) can be avoided where
they are made within three months prior to commencement. Other transactions
can be set aside if the debtor was insolvent at the time of the transaction, if the
transaction was unfair or improper in relation to a group of creditors and if the
counterparty knew that the debtor was insolvent at the time the transaction
occurred.

162. Whatever criteria are used, insolvency laws should attempt to achieve
a balance between the interests of individual creditors and those of the estate
which, in terms of the recovery of assets through avoidance actions, coincide
with the collective interests of all creditors. While in its most simple form, this
might appear to be a decision as to the party on which to impose the costs of
challenging an avoidance action, other factors need to be taken into account.
The principal of these is funding for avoidance actions. Criteria that require
proof of a number of elements for a successful avoidance action require court
proceedings to be commenced by the insolvency representative for every trans-
action it wishes to overturn, potentially representing a major expense for the
estate with no guarantee of a return. In jurisdictions that follow such an
approach, lack of funding is a major reason for avoidance actions not proceed-
ing. A different approach in which all transactions occurring within the defined
period are automatically suspect, however, does not require the use of assets
of the estate or of other funds. Further factors relevant to the setting of criteria
include the defences available to creditors subject to an avoidance action and
the duties placed upon the insolvency representative. For example, some insol-
vency laws discourage misuse of the avoidance provisions by imposing certain
duties on the insolvency representative. Professional regulation may also be
relevant, as well as the ability of the court to order costs against an insolvency
representative where the attempted avoidance action is found to have been
unjustified or to have caused unnecessary costs.

163. Whichever approach is taken, it is highly desirable that an insolvency
law provide certainty to all parties through clearly defined criteria for avoid-
ance, including the elements that will need to be proved by the insolvency
representative and the defences available to the creditors.
140                                     UNCITRAL Legislative Guide on Insolvency Law


(d)   Ordinary course of business
164. Many insolvency laws use the concept of the “ordinary course of busi-
ness” in defining their avoidance criteria, so that an extraordinary payment, as
noted above, may be subject to avoidance. The concept has wider relevance to
an insolvency regime as it may also be used, for example, to draw a distinction
between the exercise of powers regarding the use and disposition of assets
during the insolvency proceedings in the “ordinary course of business” and in
other circumstances, both in terms of who may exercise such powers and the
protections that are required (see above, paras. 75 and 76).

165. States define the “ordinary course of business” with varying emphasis
on different elements. However, in most jurisdictions a common purpose of the
definition is to determine what constitutes routine conduct of business and
allow a business to make routine payments and enter into routine contracts,
without subjecting those transactions to possible avoidance in insolvency.
Those routine payments might include the payment of rent, utilities such as
electricity and telephone and possibly also payment for trade supplies.

166. To define what constitutes “ordinary course of business” with respect to
a particular debtor, some laws focus on the prior conduct of the debtor and the
parties with which it deals, focusing on elements of their relationship such as
the method, quantity and regularity of supply and payment. In such a case, any
variation from contract, custom or what may be deemed to be regular practice
between the parties, for example a payment by abnormal means, will be re-
garded as being outside the “ordinary course of business”. Another approach
focuses on the intention of one or both of the parties and asks whether the
creditor had knowledge, or ought to have had knowledge, of the debtor’s
financial state or whether the debtor intended to prefer one creditor to others.

167. A further approach is to apply standards based upon usual industry or
even general commercial practice to the terms of the transaction and the
circumstances in which it was entered into. Other laws regard any payment
exceeding a certain percentage of the value of the debtor’s assets as extra-
ordinary.

168. It is important that a test for the “ordinary course of business” balance
flexibility, so as to not unduly restrict new developments in commercial prac-
tice, with an overriding requirement for certainty.

(e)   Defences
169. Where an insolvency law provides defences to avoidance for individual
counterparties, those defences may have the potential to dilute the efficacy of
avoidance provisions. Defences that involve elements that may be subject to
dispute, such as whether the transaction occurred in the ordinary course of
business, or the counterparty acted in good faith, or involving the state of the
counterparty’s actual or implied knowledge, can create uncertainty for all
parties and will require determination by the court. The likelihood of such
Part two:   II. Treatment of assets on commencement of insolvency proceedings                         141


uncertainty occurring has been increased in some jurisdictions by the courts
adopting a wide interpretation of such defences in favour of counterparties.
Insolvency representatives may be reluctant to use avoidance provisions as an
effective tool in an insolvency, because of associated costs or because the
procedures are inefficient and unpredictable. These potential difficulties under-
score the desirability of an insolvency law adopting clear and predictable
avoidance criteria and defences that will enable all parties to assess potential
risks and avoid disputes, for example objective criteria focusing on the effect
or result of transactions rather than on the intent of the parties. Where elements
such as “ordinary course of business” are included they should be clearly
defined and circumscribed by an insolvency law.


                  3.     Types of transaction subject to avoidance
170. Although variously defined, there are three broadly common types of
avoidable transaction that are found in most legal systems and are used in the
Legislative Guide as the basis for discussion. They are transactions intended to
defeat, hinder or delay creditors from collecting their claims; transactions at
undervalue; and transactions with certain creditors that could be regarded as
preferential. Some transactions may have the characteristics of more than one
of these different classes, depending upon the individual circumstances of each
transaction. For example, transactions that appear to be preferential may be
more in the character of transactions intended to defeat, hinder or delay
creditors when the purpose of the transaction is to put assets beyond the
reach of a creditor or potential creditor42 or to otherwise prejudice the interests
of that creditor and the transaction occurs when the debtor will be unable to
pay its debts as they become due or where they leave the debtor with insuf-
ficient assets to conduct its business. Similarly, transactions at an undervalue
may also be preferential when they involve creditors, but not when they
involve third parties. Where there is a clear intent to hinder, defeat or delay
creditors, these transactions may fall into the first category of transactions. In
cases such as these, the insolvency representative may be able to choose the
category under which a particular transaction is to be avoided and thus take
advantage of the variations in requirements of proof and suspect periods that
typically apply.

171. To achieve as much clarity and certainty as possible and avoid unneces-
sary overlap it is desirable that, in determining the categories of transaction to
be subject to avoidance provisions, an insolvency law specify the particular
characteristics of a transaction (including the effect of the transaction) that are
essential for it to be avoided, rather than relying on broader labels, such as
“fraudulent” or “preferential”.


       42
         A potential creditor may be a party that was not a creditor at the time the avoidable transaction
took place, but who was about to become a creditor through, for example, negotiation of a loan
agreement with the debtor. The debtor may have transferred assets to avoid them becoming subject
to that agreement.
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(a)   Transactions intended to defeat, hinder or delay creditors
172. Transactions intended to defeat, hinder or delay creditors involve the
debtor transferring assets to any third party with the intention of putting them
beyond the reach of creditors. The effect of such transactions will generally be
to disadvantage all unsecured creditors. These transactions generally cannot be
avoided automatically by reference to an objective test of a fixed period of
time in which the transactions occurred because of the need to prove the intent
of the debtor. That intent is rarely proven by direct evidence, but rather by
identifying circumstances that are common to these types of transaction.
Although differing between jurisdictions, there are a number of common
indicators, including:
     (a) The relationship between the parties to the transaction, where a trans-
action took place directly with a related person or via a third party to a related
person;
      (b) The lack or inadequacy of the value received for the transaction;
     (c) The financial condition of the debtor both before and after the trans-
action was entered into, in particular where the debtor was already insolvent
or became insolvent after the transaction occurred;
      (d) The existence of a pattern or series of transactions transferring some
or substantially all the debtor’s assets occurring after the onset of financial
difficulties or the threat of action by creditors;
     (e) The general chronology of the events and transactions under inquiry,
where for example, the transaction occurred shortly after a substantial debt was
incurred;
     (f) The transaction is concealed by the debtor, especially when it was
not made in the ordinary course of business, or fictitious parties were involved;
or
      (g) The debtor absconds.


173. Some laws also specify circumstances or types of transaction where the
requisite intent or bad faith is deemed, or may be presumed, to exist, for
example, in the case of transactions involving related persons occurring within
a specified period of time prior to the commencement of proceedings (dis-
cussed further below, paras. 182-184). Under other laws it may be sufficient
for a transaction to be avoided if the debtor could, and therefore should, have
realized that the effect, if not the intent, of a transaction would have been to
disadvantage creditors and that the beneficiary could, and therefore should,
have realized that the debtor’s action could produce that effect. Some laws also
provide that certain transfers, such as conveyances of land, will be exempt
from avoidance under this category of transactions if the transfer was bona fide
for good value to a person who had no notice or was unaware of any intent
to defraud creditors.
Part two:       II. Treatment of assets on commencement of insolvency proceedings   143


(b)         Undervalued transactions
      (i)     Criteria
174. A debtor who is in need of cash may sell assets quickly at a price
significantly below the real value in order to achieve a quick result, without
ever having any intention to defeat or delay creditors. The result, however,
may be a clear reduction of the assets available to creditors in insolvency. For
this reason, many insolvency laws focus on the exchange of value in a trans-
action. Transactions would generally be avoidable where the value received by
the debtor as the result of the transaction with a third party was either nominal
or non-existent, such as a gift, or much lower than the true value or market
price, provided the transaction occurred within the suspect period. Other laws
also require a finding that the transaction had a catastrophic effect on the
debtor, such as that the debtor was left with an unreasonably small amount of
capital as a result of the transaction, was insolvent at the time the transaction
occurred or became insolvent as a result of the transaction. These undervalued
transactions include those with both creditors and third parties.

175. An important question in respect of these types of transaction is what
constitutes a sufficient “undervalue” for the purposes of avoidance and how it
can be determined. In many States, it is left to the courts to determine by
reference to standards such as reasonable or market value prevailing at the time
the transaction occurred on the basis of appropriate expert evidence. Where the
relevant amounts in a transaction may not be certain, one approach to assist the
court may be for the insolvency representative to provide the court with an
estimated valuation of such amounts, which could be disputed upon the pres-
entation of further evidence by the counterparty to the transaction. The court
might also be given a power to specify a mode of determining the valuation
rather than necessarily having to determine the value itself. Given the difficul-
ties in proving undervalue, in some jurisdictions it may be easier to avoid a
transaction on the grounds of preferential effect if it was entered into at a time
when the debtor was unable to pay its due debts. Further, some laws presume
less than fair, or no, consideration to be evidence of a transaction intended to
defeat, hinder or delay creditors.

      (ii)     Defences
176. Some insolvency laws provide that these types of transaction will not be
avoided if certain conditions are satisfied, such as that the beneficiary acted in
good faith; that the transaction was for the purpose of carrying on the debtor’s
business; and that there were reasonable grounds for believing that the trans-
action would benefit the debtor’s ordinary business.

(c)         Preferential transactions

      (i)     Criteria
177. Preferential transactions may be subject to avoidance where: (a) the
transaction took place within the specified suspect period; (b) the transaction
144                                       UNCITRAL Legislative Guide on Insolvency Law


involved a transfer to a creditor on account of a pre-existing debt; and (c) as
a result of the transaction, the creditor received a larger percentage of its claim
from the debtor’s assets than other creditors of the same rank or class (in other
words, a preference). Many insolvency laws also require that the debtor was
insolvent or close to insolvent when the transaction took place and some
further require that the debtor have an intention to create a preference. The
rationale for including these types of transaction within the scope of avoidance
provisions is that, when they occur very close to the commencement of pro-
ceedings, a state of insolvency is likely to exist and they breach the key
objective of equitable treatment of similarly situated creditors by giving one
member of a class more than they would otherwise legally be entitled to
receive.

178. Examples of preferential transactions may include payment or set-off of
debts not yet due; performance of acts that the debtor was under no obligation
to perform; granting of a security interest to secure existing unsecured debts;
unusual methods of payment, for example, other than in money, of debts that
are due; payment of a debt of considerable size in comparison to the assets of
the debtor; and, in some circumstances, payment of debts in response to
extreme pressure from a creditor, such as litigation or attachment, where that
pressure has a doubtful basis. A set-off, while not avoidable as such, may be
considered prejudicial when it occurs within a short period of time before the
application for commencement of the insolvency proceedings and has the
effect of altering the balance of the debt between the parties in such a way as
to create a preference or where it involves transfer or assignment of claims
between creditors to build up set-offs. A set-off may also be subject to avoid-
ance where it occurs in irregular circumstances, such as where there is no
contract between the parties to the set-off.

  (ii)   Defences
179. One defence to an allegation that a transaction was preferential may be
to show that, although containing the elements of a preference, the transaction
was in fact consistent with normal commercial practice and, in particular, with
the ordinary course of business between the parties to the transaction. For
example, a payment made on receipt of goods that are regularly delivered and
paid for may not be preferential, even if made within proximity to the
commencement of insolvency proceedings. This approach encourages sup-
pliers of goods and services to continue to do business with a debtor that may
be having financial problems, but which is still potentially viable. Other
defences available under insolvency laws include that the counterparty
extended credit to the debtor after the transaction and that credit has not been
paid (the defence is limited to the amount of the new credit); that the
counterparty gave new value for which it was not granted a security interest;
the counterparty can show that it did not know a preference would be created;
that the counterparty did not know or could not have known that the debtor
was insolvent at the time of the transaction; or that the debtor’s assets exceeded
its liabilities at the time of the transaction. Some of these latter defences, in
particular those involving the intent of the parties to the transaction, suffer
Part two:   II. Treatment of assets on commencement of insolvency proceedings   145


from the disadvantage of being difficult to prove and may make avoidance
proceedings complex, unpredictable and lengthy.

(d)   Security interests
180. While security interests effective and enforceable under the laws per-
mitting the grant of a security interest should generally be regarded as valid
under insolvency law, they may nevertheless be avoidable in insolvency pro-
ceedings on the same grounds that any other transaction might be challenged
and avoided. The purpose of such an approach is to prevent a debtor that is not
able to pay its debts from encumbering assets, unless the security interest
provided is in consideration of new funds being advanced. Otherwise, the
encumbered assets will not be available to creditors generally and will place
restrictions on the debtor’s use of those assets. A transaction granting a
security interest might be avoided on the basis that it is a transaction intended
to defeat, delay or hinder creditors, or a preferential or undervalued trans-
action. In many cases, it will be a preferential transaction because it involves
an existing creditor. Examples of preferential transactions may include the
grant of a security interest shortly before commencement of proceedings,
which although otherwise valid, may be found to have favoured unfairly a
certain creditor at the expense of the rest; the grant of a security interest to
secure a prior debt or on the basis of past consideration (permitted in some
legal systems, but not in others); payments to a secured creditor, if the secured
creditor is undersecured and is paid in full within the suspect period. Where
the security interest is granted to a new creditor, the transaction may not be
preferential within the meaning of that category of transaction, but may be
covered by another category. There are examples of laws that include provi-
sions dealing specifically with the avoidance of such transactions, especially in
the context of security interests in favour of directors (which might also be
covered by provisions on transactions with related persons) to which different
criteria apply in terms of provision of value and the suspect period.

181. Avoidance provisions may also apply to a security interest that has not
been made effective against third parties under the relevant secured trans-
actions law and, under some laws, to a secured interest that was made effective
within a short period before the commencement of proceedings, as well as to
transfers to a secured creditor from the proceeds of an encumbered asset,
where the transaction creating the security interest was tainted.

(e)   Transactions with related persons
182. As noted above, one criterion relevant to avoidance of certain trans-
actions is the relationship between the debtor and the counterparty. Where the
types of transaction subject to avoidance involve related persons (sometimes
referred to as connected persons or insiders), insolvency laws often provide
stricter rules, in particular with regard to the length of suspect periods and
treatment of any claim by the related person (see chap. V, para. 48), as well
as presumptions or shifted burdens of proof (see below, paras. 199-201) to
facilitate avoidance proceedings and dispensing with requirements that the
146                                      UNCITRAL Legislative Guide on Insolvency Law


debtor was insolvent at the time of the transaction or was rendered insolvent
as a result of the transaction. A stricter regime may be justified on the basis
that these parties are more likely to be favoured and tend to have the earliest
knowledge of when the debtor is, in fact, in financial difficulty.

183. Related persons are generally defined by varying levels of connection
to the debtor. Most jurisdictions regard those with some form of corporate or
family relationship with the debtor as related persons. The legislative approach
taken is generally, but not always, prescriptive. With regard to those with some
form of business association with the debtor, a narrow approach would focus
on the directors or management of the debtor, while a wider definition may
extend not only to those who have effective control of the debtor, but include
all employees of the debtor and guarantors of the debts of any person with a
business connection to the debtor. Similarly, a family relationship may be
defined to include relatives by blood or marriage and even, in some laws,
persons living in the same household as the debtor, as well as trustees of any
trust of which the debtor or a person connected with the debtor is a beneficiary.
Relatives of those who have a business association with the debtor are also
commonly regarded as related persons. An important element in many juris-
dictions is to include as related persons those who had a defined relationship
with the debtor in the past or may have a defined relationship in the future.

184. Where the debtor is a natural person, other legislation (such as that
dealing with marital property) may be relevant and may affect the operation of
the insolvency law in terms of transactions that can be avoided, such as by
supplementing or limiting the avoidance provisions of the insolvency law. It is
desirable for such laws to be aligned with the insolvency law and for any effect
on the insolvency law to be clearly stated in the insolvency law.

              4.   Transactions exempt from avoidance actions
185. It may be desirable for an insolvency law to include specific exemptions
from the operation of avoidance powers for certain types of transaction. Trans-
actions essential to the functioning of financial markets, such as close-out
netting of securities and derivative contracts (see chap. II below, paras. 208-
215) are one example of transactions that should be exempted from the opera-
tion of avoidance provisions. Another example might be transactions that occur
in the course of implementing a reorganization plan, where implementation of
the plan fails and the proceedings are subsequently converted to liquidation.

         5.    Effect of avoidance: void or voidable transactions
186. Where a transaction falls into any of the categories of transactions
subject to avoidance, insolvency laws either render it automatically void or
make it voidable, depending upon the test that is adopted in respect of each
category of transaction. For example, those laws which refer only to transac-
tions occurring within a certain fixed period of time and include no subjective
criteria sometimes specify that relevant transactions will be void. However,
Part two:   II. Treatment of assets on commencement of insolvency proceedings   147


even where that approach is adopted the insolvency representative may have
to commence proceedings to recover the assets or their equivalent value from
the counterparty where the counterparty fails to return the assets or pay for
their value.

187. In those laws where the transaction is voidable, the insolvency repre-
sentative will be required to decide whether avoidance of the transaction will
be beneficial to the estate, taking into account the elements of each category
of avoidable transaction as well as possible delays in recovering either the
assets involved or the value of the assets and the possible costs of litigation.
That discretion would generally be subject to the insolvency representative’s
obligation to maximize the value of the estate and, under some laws, it may
be responsible for its failure to do so.


                        6.   Establishing the suspect period
188. Most insolvency laws explicitly specify the duration of the suspect
period with reference to the particular types of transaction to be avoided and
indicate the date from which the period is calculated retroactively. For exam-
ple, so many days or months before a particular event or date, such as the date
the application for commencement of proceedings is made, the effective date
of commencement of insolvency proceedings or the date decided by the court
as being the date on which the debtor ceased paying its debts in the normal
way (“cessation of payments”). The event or date specified by the law will
depend upon other design features of the insolvency regime such as the re-
quirements for commencement, including whether there is a potential for delay
between the application for, and commencement of, insolvency proceedings.
For example, if commencement typically takes several months from the time
of application and the suspect period is a fixed period relating back from the
effective date of commencement, then several months of that period will be
taken up by the period of delay between application and commencement, thus
limiting the potential effectiveness of the avoidance powers. However, if the
proceedings commence automatically when an application is made, the same
delay will not occur. To address situations where there is the potential for delay
to occur, an insolvency law could stipulate that the suspect period applies
retroactively from the date an application is made and address transactions
between application and commencement in other terms, such as whether they
were fraudulent or whether they were in the ordinary course of business or,
where an interim insolvency representative is appointed, in terms of unautho-
rized transactions (see above, paras. 70-73). Where commencement occurs
shortly after application, the suspect period could apply retroactively from the
effective date of commencement.

189. Some insolvency laws provide one suspect period for all types of avoid-
able transaction, while others have different periods depending upon the type
of transaction and whether the transferee was a related person. As noted above,
there are also examples of laws that adopt the approach of combining a short
suspect period within which certain types of transaction are automatically
148                                        UNCITRAL Legislative Guide on Insolvency Law


avoided (and no defences are available) and a longer period where additional
elements have to be proved. Because some transactions involve intentionally
wrongful conduct, many insolvency laws do not limit the time period within
which these types of transaction must have occurred in order for them to be
avoided. Other insolvency laws establish a very long limit (examples range
from 1 to 10 years) where the suspect period is generally calculated from the
date of commencement of proceedings. With the exception of transactions
involving intentionally wrongful behaviour, it is highly desirable that suspect
periods be of a reasonably short duration to ensure commercial certainty and
to reduce any negative impact that avoidance provisions will have on the
availability and cost of credit.

190. Where preferential and undervalued transactions involve creditors who
are not related persons, it is desirable that the suspect period be relatively brief,
perhaps no more than several months (e.g. from three to six months). However,
where related persons are involved, stricter rules may apply and the suspect
period will be longer (e.g. two years as opposed to three to six months for the
same transaction when it does not involve a related person). For transactions
intended to defeat, hinder or delay creditors, the suspect period could be
longer, for example, one to two years.

191. A related issue is whether suspect periods stipulated in the insolvency
law can be extended by the court in appropriate situations, such as where
transactions that occurred outside the specified suspect periods in questionable
circumstances had the effect of diminishing the estate. While a discretionary
approach may allow a certain degree of flexibility with respect to the trans-
actions to be caught by the avoidance provisions, it may also lead to delay in
the proceedings and does not give a predictable or transparent indication to
creditors as to the transactions that are likely to be avoided. If transactions can
be unwound where they took place at some unspecified time prior to the
commencement of insolvency proceedings and subject to the discretion of the
court, there is likely to be less safety in commercial and financial transactions.
For these reasons, it is desirable that extension of the suspect period be limited
to transactions intended to defeat, hinder or delay, where issues of commercial
certainty are of less concern.

                   7.   Conduct of avoidance proceedings
(a)   Parties who may commence
192. Avoidance of a particular transaction generally requires an application
to the court to declare the transaction void and insolvency laws adopt a variety
of approaches to the party that may commence such a proceeding. Recognizing
the central role played by the insolvency representative with respect to the
administration of the estate, many insolvency laws provide that proceedings for
the avoidance of specified transactions should be taken by the insolvency
representative, although some do require the insolvency representative to gain
the agreement of creditors or a majority of creditors before any proceeding can
be commenced. There are also laws that permit avoidance proceedings to be
Part two:   II. Treatment of assets on commencement of insolvency proceedings                   149


commenced by creditors (and, in some cases, the creditor committee), some of
which limit the right to commence to those creditors whose debt precedes the
challenged transaction in time. Some of the laws that permit creditors to com-
mence such proceedings require the prior consent of the insolvency representa-
tive. Should it be regarded as desirable to include such permission in an insol-
vency law, requiring consent ensures that the insolvency representative is
informed as to what creditors propose and gives it the opportunity to refuse
permission, thus avoiding any negative impact of avoidance proceedings on
administration of the estate.

193. Where the consent of the insolvency representative is required, but not
obtained, some insolvency laws permit a creditor to seek court approval to
commence avoidance proceedings. The insolvency representative has a right to
be heard in any resulting court hearing to explain why it believes the proceed-
ings should not go ahead. At such a hearing, the court might give leave for the
avoidance proceeding to be commenced or may decide to hear the case on its
own merits. Such an approach may work to reduce the likelihood of any deal-
making between the various parties. Where creditor-initiated avoidance actions
are permitted, some laws require creditors to pay the costs of those proceedings
or allow sanctions to be imposed on creditors to discourage potential abuse of
avoidance proceedings.

194. Where the insolvency representative has the sole power to commence
avoidance proceedings and, based on the balance of the considerations dis-
cussed above (i.e. for reasons other than negligence, bad faith or omission),43
decides not to commence proceedings in respect of certain transactions, insol-
vency laws adopt different approaches to the conduct and funding of those
proceedings. The manner in which they could be funded may be of particular
importance where the insolvency estate has insufficient assets to do so (fund-
ing is discussed further below). As to the conduct of those proceedings, some
laws permit a creditor or the creditor committee to require the insolvency
representative to initiate an avoidance proceeding where it appears to be
beneficial to the estate to do so or also permit a creditor itself or the creditor
committee to commence proceedings to avoid these transactions, where other
creditors agree.

195. Where creditors are permitted to commence avoidance proceedings,
either on an equal basis with the insolvency representative or because the
insolvency representative decides not to commence such proceedings, insol-
vency laws adopt different approaches to the assets or value recovered. The
most common approach is to treat the assets or value recovered by the creditor
as part of the estate on the basis that the principal justification of avoidance
proceedings is to return value or assets to the estate for the benefit of all
creditors, rather than to provide a benefit to individual creditors. Other laws
provide that whatever is recovered can be applied in the first instance to satisfy
the claim of the creditor that commenced the proceedings, or that the priority
of the claim of the creditor or creditors pursuing the action can be modified.

     43
       See chap. III, paras. 49-52, on the duties and functions of the insolvency representative.
150                                      UNCITRAL Legislative Guide on Insolvency Law


(b)   Funding of avoidance proceedings
196. The most crucial restriction in a number of States on the efficacy of
avoidance provisions has been the unavailability of funds with which to chal-
lenge potentially avoidable transactions. Different approaches to the question
of funding have been adopted. Some States make public funds available to the
insolvency representative to commence avoidance proceedings, while others
require those proceedings to be funded from the insolvency estate. This latter
approach may be appropriate where sufficient funds exist, but in some circum-
stances would prevent the recovery of assets that have been removed from the
estate with the specific intention of leaving the estate with few assets from
which to fund their recovery through avoidance proceedings. Some insolvency
laws allow the insolvency representative to assign the ability to commence
proceedings for value to a third party or to approach a lender to advance funds
with which to commence avoidance proceedings. There are clearly significant
differences between countries in the availability of public resources to fund
avoidance proceedings that may justify use of some of these alternative mecha-
nisms. Where there is no ability to fund avoidance proceedings from the insol-
vency estate, these alternative approaches may offer, in appropriate situations,
an effective means of restoring value to the estate, avoiding abuse, investi-
gating unfair conduct and furthering good governance.

(c)   Time limits for commencement of avoidance proceedings
197. Some insolvency laws establish specific time periods within which
avoidance proceedings should be commenced, while others are silent on this
issue. Those laws which do specify time periods provide, for example, that the
proceedings should be commenced within a specified period after the effective
date of commencement of insolvency proceedings (e.g. 3 or 12 months) or no
later than a specified time period (e.g. 6 months) after the insolvency repre-
sentative is able to discover, assess and pursue claims. If an insolvency law is
to establish specific time periods, rather than relying on those applicable under
law other than the insolvency law, an approach that combines different periods,
such as a fixed time period after commencement and a fixed time period after
the discovery of the transaction by the insolvency representative, would be
desirable. Such an approach provides sufficient flexibility to address those
transactions which are concealed from the insolvency representative and dis-
covered only after the expiration of the specified time period. Whichever ap-
proach is adopted, it is desirable that the time period be relatively short, as in
the examples noted above, to avoid uncertainty and ensure that the insolvency
proceedings are conducted expeditiously.

(d)   Satisfying the criteria for avoidance
198. Insolvency laws adopt different approaches to establishing the elements
that have to be proved in order to avoid a particular transaction. The approach
adopted will depend upon how the balance is struck between undoing transac-
tions that are unfair or financially harmful to the insolvency estate on the one
hand and protecting commercial transactions that are not regarded as wrong or
harmful outside the insolvency context on the other. Whichever approach an
Part two:   II. Treatment of assets on commencement of insolvency proceedings   151


insolvency law adopts to satisfying the avoidance criteria, it is highly desirable
that the law state precisely which parts of the criteria have to be proved by
which party, so that it is clear what is required of the insolvency representative
in seeking to avoid a particular transaction and what is required of the
counterparty seeking to defend a transaction from avoidance.

199. In some laws, the onus is on the debtor to prove that the transaction did
not fall into any category of avoidable transactions and, for example, was a
transaction in the ordinary course of business. Other insolvency laws provide
that the insolvency representative or other person permitted to challenge the
transaction, such as a creditor, is required to prove that the transaction satisfies
the requirements for avoidance. Where these elements include intent, it will
often be very difficult to prove and the party with the burden of proof will most
often lose. To overcome this difficulty, some laws allow the burden of proof
to be shifted to the counterparty where, for example, it is difficult for the
insolvency representative to establish that the debtor’s actual intent was to
defraud creditors except through external indications, objective manifestations,
or other circumstantial evidence of such intent. As a practical matter, however,
the debtor’s inability to satisfactorily explain the commercial purpose of a
particular transaction, which extracted value from the estate, may point to the
requisite intent.

200. Another approach is to provide that the requisite intent or bad faith is
deemed or presumed to exist where certain types of transaction are undertaken
within the suspect period and the counterparty to the transaction will have the
burden of proving otherwise. These types of transaction may include, for
example, transactions with related persons, payment of unmatured debts and
payment of gratuitous or onerous transactions. A further approach is to provide
that where a certain type of transaction occurred within the suspect period and
had a certain effect, such as conferring a preference, a rebuttable presumption
as to intention to prefer will arise. Unless the counterparty can rebut the pre-
sumption, the transaction will be avoided and the insolvency representative can
recover the assets involved in the transaction or obtain judgement for the value
of the asset involved.

201. Where the counterparty’s knowledge of the debtor’s insolvency is a
required element of avoidance, some insolvency laws include a presumption
that the counterparty knew of the poor financial condition of the debtor if the
transaction entered into with that person had certain characteristics. These may
include that the repayment was in respect of an unmature debt or made in an
unusual manner, or that the transaction occurred within a short period before
an application for commencement or before commencement of insolvency
proceedings.

            8.   Liability of counterparties to avoided transactions
202. Where a transaction is avoided, there is a question of the effect of
avoidance on the counterparty. In most insolvency laws the result of avoidance
of a transaction is that the transaction will be reversed and the counterparty
152                                                   UNCITRAL Legislative Guide on Insolvency Law


will be required to return the assets obtained or make a cash payment for the
value of the transaction to the insolvency estate. Some insolvency laws provide
that the insolvency representative can be awarded judgement for the value of
the property involved. Some insolvency laws also stipulate that a counterparty
that has returned assets or value to the estate may make a claim as an
unsecured creditor in the insolvency to the extent of the assets returned in the
case of a preference and to the extent of the consideration paid in an under-
valued transaction. Where the counterparty fails to disgorge assets or return
value to the insolvency estate, most of the remedies available are under non-
insolvency law. Some insolvency laws provide, however, that in addition to
avoidance of the transaction, a claim by the counterparty (for amounts owed
in addition to those involved in the voidable transaction) cannot be admitted
in the insolvency.

                 9.    Conversion of reorganization to liquidation
203. Where reorganization proceedings are converted to liquidation proceed-
ings, some consideration may need to be given to the effect of that conversion
on the exercise of avoidance powers in respect of payments made in the course
of the reorganization proceedings and the timing of the suspect period.



                                    Recommendations 87-99

           Purpose of legislative provisions
           The purpose of avoidance provisions is:
           (a) To reconstitute the integrity of the estate and ensure the equitable
      treatment of creditors;
           (b) To provide certainty for third parties by establishing clear rules for
      the circumstances in which transactions occurring prior to the commencement
      of insolvency proceedings involving the debtor or the debtor’s property may
      be considered injurious and therefore subject to avoidance;
           (c) To enable the commencement of proceedings to avoid those transac-
      tions; and
           (d) To facilitate the recovery of money or assets from persons involved
      in transactions that have been avoided.

      Contents of legislative provisions
      Avoidable transactions44 (paras. 170-179)
          87. The insolvency law should include provisions that apply retroactively
      and are designed to overturn transactions, involving the debtor or assets of the

       44
          The use of the word “transaction” in this section is intended to refer generally to the wide range
of legal acts by which assets may be disposed of or obligations incurred including by way of a transfer,
a payment, granting of a security interest, a guarantee, a loan or a release or an action to make a security
interest effective against third parties and may include a composite series of transactions.
Part two:   II. Treatment of assets on commencement of insolvency proceedings           153




     estate, and that have the effect of either reducing the value of the estate or
     upsetting the principle of equitable treatment of creditors. The insolvency law
     should specify the following types of transaction as avoidable:
          (a) Transactions intended to defeat, delay or hinder the ability of credi-
     tors to collect claims where the effect of the transaction was to put assets
     beyond the reach of creditors or potential creditors or to otherwise prejudice
     the interests of creditors;
          (b) Transactions where a transfer of an interest in property or the under-
     taking of an obligation by the debtor was a gift or was made in exchange for
     a nominal or less than equivalent value or for inadequate value that occurred
     at a time when the debtor was insolvent or as a result of which the debtor
     became insolvent (undervalued transactions); and
          (c) Transactions involving creditors where a creditor obtained, or re-
     ceived the benefit of, more than its pro rata share of the debtor’s assets that
     occurred at a time when the debtor was insolvent (preferential transactions).

     Security interests (para. 180)

           88. The insolvency law should specify that, notwithstanding that a secu-
     rity interest is effective and enforceable under law other than the insolvency
     law, it may be subject to the avoidance provisions of insolvency law on the
     same grounds as other transactions.

     Establishing the suspect period (paras. 188-191)

          89. The insolvency law should specify that the transactions described in
     recommendation 87, subparagraphs (a)-(c), may be avoided if they occurred
     within a specified period (the suspect period) calculated retroactively from a
     specified date, being either the date of application for, or commencement of,
     the insolvency proceedings. The insolvency law may specify different suspect
     periods for different types of transaction.

     Transactions with related persons (paras. 182-184)

          90. The insolvency law may specify that the suspect period for avoidable
     transactions involving related persons is longer than for transactions with
     unrelated persons.

          91. The insolvency law should specify the categories of persons with
     sufficient connection to the debtor to be treated as related persons.45

     Transactions exempt from avoidance actions (para. 185)

         92. The insolvency law should specify the transactions that are exempt
     from avoidance, including financial contracts.




     45
       “Related person” is defined in the glossary (see Introduction, para. 12 (jj)).
154                                                UNCITRAL Legislative Guide on Insolvency Law




      Recommendations 87-99 (continued)

      Conduct of avoidance proceedings (paras. 192-195)

           93. The insolvency law should specify that the insolvency representative
      has the principal responsibility to commence avoidance proceedings.46 The
      insolvency law may also permit any creditor to commence avoidance proceed-
      ings with the agreement of the insolvency representative and, where the insol-
      vency representative does not agree, the creditor may seek leave of the court
      to commence such proceedings.


      Funding of avoidance proceedings (para. 196)

          94. The insolvency law should specify that the costs of avoidance pro-
      ceedings be paid as administrative expenses.

           95. The insolvency law may provide alternative approaches to address
      the pursuit and funding of avoidance proceedings.


      Time limits for commencement of avoidance proceedings (para. 197)

           96. The insolvency law or applicable procedural law should specify the
      time period within which an avoidance proceeding may be commenced. That
      time period should begin to run on the commencement of insolvency proceed-
      ings. In respect of transactions referred to in recommendation 87 that have
      been concealed and that the insolvency representative could not be expected
      to discover, the insolvency law may provide that the time period commences
      at the time of discovery.


      Elements of avoidance and defences (paras. 198-201)

           97. The insolvency law should specify the elements to be proved in order
      to avoid a particular transaction, the party responsible for proving those ele-
      ments and specific defences to avoidance. Those defences may include that the
      transaction was entered into in the ordinary course of business prior to com-
      mencement of insolvency proceedings. The law may also establish presump-
      tions and permit shifts in the burden of proof to facilitate the conduct of
      avoidance proceedings.


      Liability of counterparties to avoided transactions (para. 202)

           98. The insolvency law should specify that a counterparty to a transac-
      tion that has been avoided must return to the estate the assets obtained or, if


       46
          Issues relevant to avoidance may also arise in proceedings commenced by a person other than
the insolvency representative, where the insolvency representative raises avoidance by way of defence
against enforcement.
Part two:   II. Treatment of assets on commencement of insolvency proceedings       155




     the court so orders, make a cash payment to the estate for the value of the
     transaction. The insolvency law should determine whether the counterparty to
     an avoided transaction would have an ordinary unsecured claim.
          99. The insolvency law may specify that, where the counterparty does
     not comply with the court order avoiding the transaction, in addition to
     avoidance and any other remedy, a claim by the counterparty may be
     disallowed.




                                  G.   Rights of set-off
204. The enforcement under insolvency law of rights of set-off of mutual
obligations arising out of pre-commencement transactions or activities of the
debtor is important not only to commercial predictability and the availability
of credit, but also because it avoids the strategic misuse of insolvency proceed-
ings. For these reasons, it is highly desirable that an insolvency law afford
protection to such set-off rights.

205. In the majority of jurisdictions, set-off rights are not affected by the stay
in insolvency and may be exercised after the commencement of insolvency
proceedings, irrespective of whether the mutual obligations arose under a
single contract or multiple contracts and irrespective of whether the mutual
obligations matured before or after commencement of insolvency proceedings.
In some jurisdictions a distinction is made; post-commencement set-off of
obligations maturing prior to the commencement of insolvency proceedings is
permitted, but post-commencement set-off of obligations maturing after the
commencement of insolvency proceedings is limited or disallowed.

206. An alternative approach preserves set-off rights regardless of whether
the mutual obligations matured prior to or after the commencement of insol-
vency proceedings, but applies the stay to the exercise of those rights in the
same manner as the stay applies to the exercise of rights of secured creditors.
In systems adopting this alternative approach, the creditor is treated as secured
to the extent of its own valid but unexercised set-off rights and those rights are
protected in a manner similar to the protections afforded to security interests.47

207. Insolvency laws almost universally include provisions that permit
the insolvency representative to seek to avoid the effects of certain pre-
commencement actions by creditors designed to enhance set-off rights (such as
purchasing claims at a discount with the intention of building up set-off rights).
The nature and scope of such provisions varies.


     47
       See above, paras. 59-69.
156                                           UNCITRAL Legislative Guide on Insolvency Law




                                Recommendation 100

      Purpose of legislative provisions

          The purpose of provisions on set-off is:
           (a) To provide certainty with respect to the effect of the commencement
      of insolvency proceedings upon the exercise of set-off rights;
         (b) To specify the types of obligation that may be set off after com-
      mencement of insolvency proceedings; and
          (c) To specify the effect of other provisions of the law (e.g. avoidance
      provisions and the stay) on the exercise of rights of set-off.

      Contents of legislative provisions

           100. The insolvency law should protect a general right of set-off existing
      under law other than the insolvency law that arose prior to the commencement
      of insolvency proceedings, subject to the application of avoidance provisions.




                     H. Financial contracts and netting
208. Financial contracts have become an important component of inter-
national capital markets. Among other things, they enhance the availability of
credit and are an important means of hedging against exchange rate, interest
rate and other market fluctuations. Because of the way these transactions are
structured and documented, it is imperative that there be certainty as to what
happens when one of the parties to such contracts fails to perform—including
for reasons of insolvency.

209. Financial contracts include, among other things, securities contracts,
commodities contracts, forward contracts, options, swaps, securities repurchase
agreements, master netting agreements and other similar contracts. Debtors
often enter into multiple financial contracts with a given counterparty in a
single course of dealing and the availability of credit is enhanced if rights
under those contracts are fully enforceable in accordance with their terms,
thereby permitting counterparties to extend credit based on their net exposure
from time to time after taking into account the value of all “open” contracts.

210. Upon commencement of insolvency proceedings, counterparties seek to
“close-out” open positions and “net” all obligations arising under financial
contracts with the debtor. “Close-out netting” embraces two steps: firstly,
termination of all open contracts as a result of the commencement of insol-
vency proceedings (close-out); secondly, the set-off of all obligations arising
out of the closed out transactions on an aggregate basis (netting).
Part two:   II. Treatment of assets on commencement of insolvency proceedings                      157


211. Permitting “close-out netting” after the commencement of insolvency
proceedings is an important factor in mitigating systemic risks that could
threaten the stability of financial markets. The value of or exposure under a
financial contract may vary significantly from day to day (and sometimes from
hour to hour) depending on conditions in the financial markets. Accordingly,
the value of these contracts can be highly volatile. Counterparties typically
mitigate or hedge the risks associated with these contracts by entering into one
or more “matching” or “hedge” contracts with third parties, the value of which
fluctuates inversely with the value of the debtor’s contract.48

212. Whether or not the debtor performs its contract with the counterparty,
the counterparty must perform the hedge contract it enters into with third
parties. If the debtor becomes insolvent and cannot perform its contract with
the counterparty, the counterparty becomes exposed to market volatility
because its hedge positions are no longer “covered” by its contract with the
debtor. Under such circumstances, the counterparty typically seeks to “cover”
the hedge contracts by entering into one or more new contracts so as to limit
its exposure to future market fluctuations. The counterparty cannot, however,
cover in this manner until it determines with certainty that it will not be
required to perform its contract with the debtor. The counterparty relies on the
ability to close out the debtor’s contract, which permits it to cover promptly
after the commencement of insolvency proceedings.

213. Without the ability to close out, net and set off obligations in respect of
defaulted contracts promptly after commencement of insolvency proceedings
as described above, a debtor’s failure to perform its contract (or its decision to
perform profitable contracts and not perform unprofitable ones) could lead the
counterparty to be unable to perform its related financial contracts with other
market participants. The insolvency of a significant market participant could
result in a series of defaults in back-to-back transactions, potentially causing
financial distress to other market participants and, in the worst case, resulting
in the financial collapse of other counterparties, including regulated financial
institutions. This domino effect is often referred to as systemic risk, and is
cited as a significant policy reason for permitting participants to close out, net
and set off obligations in a way that normally would not be permitted by
insolvency law.

214. Systemic risk can also arise from concerns over the finality of payments
and settlements of financial contracts that take place in central payment and
settlement systems. These systems employ either bilateral or multilateral
netting arrangements. The netting of financial contracts through these systems
and the finality of clearing and settlement through them should be recognized
and protected upon the insolvency of one of the participants in the system in
order to prevent systemic risk.


     48
       The reference to a “contract” in this section includes the possibility of one or more contracts.
158                                               UNCITRAL Legislative Guide on Insolvency Law


215. In many States, the application of general insolvency rules will allow
the financial contracts to be performed in accordance with their terms follow-
ing commencement of insolvency proceedings by giving effect to contract
termination clauses triggered by insolvency (see above, paras. 114-119 and
recommendations 70 and 71) and by allowing the set-off of obligations,
whether a claim for breach is based on an automatic termination clause or
arises pre-commencement. Other jurisdictions, with insolvency provisions that
limit the effect of automatic termination clauses or that stay or limit the exer-
cise of set-off rights and other creditor remedies, require specific exceptions in
their insolvency laws to permit full enforcement of remedies in respect of
financial contracts. It is also desirable that the exceptions extend to avoidance
provisions that otherwise might apply to financial contracts and any restrictions
that would limit the extent to which security can be applied to unsatisfied
financial contract obligations remaining after set-offs are completed. The ex-
ceptions for financial contracts should be drafted broadly enough to protect the
significant interests of parties that deal in financial contracts and to prevent
systemic risk.




                               Recommendations 101-107

      Purpose of legislative provisions

           The purpose of provisions on netting and set-off in the context of financial
      transactions on financial markets is to reduce the potential for systemic risk
      that could threaten the stability of financial markets by providing certainty
      with respect to the rights of parties to a financial contract when one of those
      parties fails to perform for reasons of insolvency. These recommendations are
      not intended to apply to transactions that are not financial contracts and they
      would remain subject to the law applicable to set-off and netting.

      Contents of legislative provisions

           101. The insolvency law should recognize contractual termination rights
      associated with financial contracts that permit the termination of those con-
      tracts and the set-off and netting of outstanding obligations under those con-
      tracts promptly after the commencement of insolvency proceedings. Where the
      insolvency law stays the termination of contracts or limits the enforceability of
      automatic termination clauses on commencement of insolvency proceedings,
      financial contracts should be exempt from such limitations.49



      49
         This will allow market participants to extend credit based on “net” positions and make it
impossible for the debtor to “cherry-pick” contracts by performing some and breaching others, which
is especially important with regard to financial contracts because of systemic risk.
Part two:   II. Treatment of assets on commencement of insolvency proceedings                          159




          102. Once the financial contracts of the debtor have been terminated by
     a counterparty, the insolvency law should permit the counterparty to net or set
     off obligations under those terminated financial contracts to establish a net
     exposure position relative to the debtor. This termination and set-off to
     establish a net exposure should be permitted regardless of whether the
     termination of the contracts occurs prior to or after the commencement of
     insolvency proceedings. Where the insolvency law limits or stays the exercise
     of set-off rights upon commencement of insolvency proceedings, set-off and
     netting of financial contracts should be exempt from such limitations.

          103. Once the financial contracts of the debtor have been terminated, the
     insolvency law should permit counterparties to enforce and apply their security
     interest to obligations arising out of financial contracts. Financial contracts
     should be exempt from any stay under the insolvency law that applies to the
     enforcement of a security interest.

          104. The insolvency law should specify that routine pre-bankruptcy
     transfers consistent with market practice, such as the putting up of margin for
     financial contracts50 and transfers to settle financial contract obligations,51
     should be exempt from avoidance.

           105. The insolvency law should recognize and protect the finality of the
     netting, clearing and settlement of financial contracts through payment and
     settlement systems upon the insolvency of a participant in the system.

          106. Recommendations 101-105 should apply to all transactions that are
     considered to be “financial contracts”, whether or not one of the counterparties
     is a financial institution.52

          107. Financial contracts should be defined broadly enough to encompass
     existing varieties of financial contract and to accommodate new types of
     financial contract as they appear.




       50
         “Margin” is the process of posting additional cash or securities as a security for the transac-
tions in accordance with a contractual formula that accounts for fluctuations in the market value of
the contract and the existing security. For example, on a swap, a margin of 105 per cent might be
required to maintain the termination value of the contract. If the security position falls to 100 per cent,
an additional margin might have to be posted.
       51
         In some circumstances, a settlement payment might be viewed as a preference. In the example
of a swap, settlement payments are to be made monthly or upon termination of the contract based on
the market value of the contract. These payments are not value for value transfers, but rather payment
of an accrued debt obligation that has matured. In countries that have a fixed suspect period for all
transactions occurring before commencement, such a payment might also be subject to avoidance.
       52
         Even if a given financial contract does not involve a financial institution, the impact of the
insolvency of a counterparty could entail systemic risk.
                                   III.      Participants
                                       A.     The debtor1
                                       1.     Introduction
1. Insolvency laws adopt different approaches to the role the debtor plays in
the insolvency proceedings, with a distinction generally being drawn between
liquidation and reorganization. Where the business is to be continued (either
for sale as a going concern in liquidation or in reorganization), a greater need
arises for some form of involvement of the debtor in management. The debtor
will also have a role to play in assisting the insolvency representative to per-
form its own functions and providing information on the business to the court
or the insolvency representative. In addition to obligations, the debtor will have
certain rights with regard to those proceedings, such as to be heard in proceed-
ings, to access information and to retain personal property. To ensure the
efficient and effective conduct of the proceedings and provide certainty for all
parties involved, it is desirable that an insolvency law establish clearly the
extent of the debtor’s rights and obligations.


            2.    Continued operation of the debtor’s business and
                             the role of the debtor
(a)    Liquidation
2. Once liquidation proceedings have commenced, the conservation of the
estate requires comprehensive measures to protect the estate not only from the
actions of creditors, but also from the debtor. For this reason, many insolvency
laws divest the debtor of all rights to control assets and manage and operate
the business in liquidation and appoint an insolvency representative to assume
all responsibilities divested. In addition to the powers relating to use and dis-
posal of assets, those responsibilities may include the right to initiate and
defend legal actions on behalf of the estate and the right to receive all pay-
ments directed to the debtor. After commencement of the liquidation proceed-
ings, any transaction involving assets of the estate, including transfer of those
assets, that is not authorized by the insolvency representative, the court or
creditors (depending on the requirements of the insolvency law) generally will


      1
        Because the insolvency law will cover different types of business, whether sole traders, part-
nerships or some form of company, the question of the continuing role of the debtor properly raises
questions of the role of the debtor’s management or owners, depending upon the circumstances. For
ease of reference, the Legislative Guide refers only to “the debtor”, but it is intended that management
and owners should be covered by the use of that term where appropriate.


                                                  161
162                                      UNCITRAL Legislative Guide on Insolvency Law


be void (or under some laws subject to avoidance) and the assets transferred
(or their value) subject to recovery for the benefit of the insolvency estate (see
chap. II, paras. 70-73).

3. Where it is determined that the most effective means of liquidating the
estate is to sell the business as a going concern, some laws provide that the
insolvency representative should supervise and have overall control of the
business while permitting the debtor to enhance the value of the estate and
facilitate the sale of the assets by continuing to serve and advise the insolvency
representative. This approach may be supported by the debtor’s detailed
knowledge of its business and the relevant market or industry, as well as its
ongoing relationship with creditors, suppliers and customers.

(b)     Reorganization
4. In reorganization proceedings, there is no agreed approach on the extent
to which displacement of the debtor is the most appropriate course of action
and, where some level of displacement does occur, on the ongoing role that the
debtor may perform and the manner in which that role is balanced with the
roles of other participants. That ongoing role may depend in large part upon
the debtor acting in good faith during the reorganization proceedings; where it
does not, its continuing role may be of questionable value. It may also depend
upon the existence of a strong, independent governance regime that can
address incompetent or self-serving behaviour. Sometimes the advantages of a
continuing role may also depend upon whether the debtor commenced the
proceedings or whether they were commenced on the application of creditors.
In the latter case the debtor may be uncooperative or even hostile to an extent
that makes its continued participation pointless. The decision on which
approach to take may depend upon a number of factors, including local cor-
porate culture; the role of banks; the existence and effectiveness of corporate
governance regimes; the effectiveness of insolvency institutions; the level of
supervision provided by, or required of, the courts; the effectiveness and
accessibility of the courts; and the extent to which incentives to commence
insolvency proceedings are determined to be of importance to the design of the
insolvency regime.

  (i)     Advantages and disadvantages of the debtor’s
          continuing involvement
5. There are a number of potential advantages in allowing the debtor to have
an ongoing role. In many circumstances, the debtor will have immediate and
intimate knowledge of its business and the industry within which it operates.
This knowledge is particularly important in the case of sole traders and small
partnerships and, in the interests of business continuity, may provide a basis
for the debtor to have a role in making short term and day-to-day management
decisions. It may also assist the insolvency representative to perform its func-
tions with a more immediate and complete understanding of the operation of
the debtor’s business. For similar reasons, the debtor is often well positioned
to propose a reorganization plan. In such circumstances, total displacement of
Part two: III. Participants                                                    163


the debtor, notwithstanding its role in the financial difficulties of the business,
may not only eliminate an incentive for entrepreneurial activity, risk-taking in
general and for debtors to commence reorganization procedures at an early
stage, but also may undermine the chances of success of the reorganization.

6. The desirability of the debtor having an ongoing role may need to be
balanced against a number of possible disadvantages. Creditors may have a
lack of confidence in the debtor on account of the financial difficulties of the
business (and the role that the debtor may have played in those difficulties) and
confidence will need to be rebuilt if the reorganization is to be successful.
Permitting the debtor to continue to operate the business with insufficient
control over its powers may not only exacerbate the breakdown of confidence
but may antagonize creditors further. One factor that may affect creditors’
views of this option is the effectiveness of any applicable corporate governance
regime and the responsiveness of the debtor to that regime. Where there is no
effective governance regime, creditors may prefer an appointed insolvency
representative to displace the debtor or to have significant supervisory powers
over the debtor.

7. A system that is perceived to be excessively pro-debtor may result in
creditors being apathetic about the proceedings and unwilling to participate,
which in turn may lead to problems of monitoring the conduct of the debtor
where the insolvency law requires that role to be played by creditors. It may
also encourage an adversarial approach to the insolvency proceedings, adding
to costs and delay. A debtor may have its own agenda that clashes with the
objectives of the insolvency regime and in particular with the maximization of
returns for creditors. The debtor’s overriding goal, for example, may be to
ensure that it does not lose control of the business rather than to maximize
value for the benefit of creditors. Furthermore, the success of reorganization
may depend not only upon instituting change that the debtor may not be
willing to accept, but also upon the debtor possessing the knowledge and
experience to utilize the insolvency law to work through its financial difficul-
ties. A related factor to be considered is whether the insolvency proceedings
were commenced on application of the debtor or of creditors (in which case the
debtor may be hostile to creditors).

8. A number of insolvency laws draw a distinction, in terms of the debtor’s
role, between the period from commencement of proceedings to approval of
the reorganization plan, on the one hand, and the period following approval of
the plan, on the other hand. In the first period these laws set out specific rules
concerning the debtor’s ability to manage and control the day-to-day running
of the business and the appointment of an independent insolvency representa-
tive. Once the plan has been approved, the limits applicable to the debtor’s
control and management of the business may cease to apply and the debtor will
be responsible for implementation of the approved plan.

9. Insolvency laws adopt different approaches to balancing these competing
considerations in reorganization. These vary between displacing the debtor and
appointing an insolvency representative, at one end of the scale, and allowing
164                                      UNCITRAL Legislative Guide on Insolvency Law


the debtor to remain in control of the business with minimum supervision at
the other. Intermediate approaches provide for an insolvency representative to
be appointed to exercise some level of supervisory function, as well as for
retention of existing management. The choice between these various ap-
proaches has implications for the structure of the insolvency regime and in
particular for the balance to be achieved between the various participants and
the extent to which checks and balances, whether provided by the court or
creditors, will apply. It should be borne in mind in considering the debtor’s
role that, where the debtor is a legal entity, the management at the time of
commencement of the insolvency will not necessarily remain in place through-
out the proceedings.

  (ii) Approaches to a continuing role for the debtor
      a.   Total displacement of the debtor
10. This approach follows the same procedure as in liquidation, removing all
control of the business from the debtor and appointing an insolvency repre-
sentative to undertake the debtor’s functions with respect to management of the
business. As noted above, however, total displacement of the debtor may cause
disruption to the business and repercussions detrimental to its continuing
operation at a critical point in its survival.

      b.   Supervision of the debtor by the insolvency representative
11. Intermediate approaches establish different levels of control between the
debtor and the insolvency representative. These generally involve some level
of supervision of the debtor by the insolvency representative, such as where
the latter broadly supervises the activities of the debtor and approves signifi-
cant transactions, while the debtor continues to operate the business and take
decisions on a day-to-day basis. This approach may need to be supported by
relatively precise rules to ensure that the division of responsibility between the
insolvency representative and the debtor is clear and that there is certainty as
to how the reorganization will proceed. Some insolvency laws, for example,
specify that certain transactions, such as entering into new debt, transferring or
pledging assets and granting rights to the use of property of the insolvency
estate can be undertaken without the consent of the insolvency representative
or the court provided they are undertaken in the ordinary course of business.
If they are not in the ordinary course of business, consent is required. Moni-
toring the cash flow of the debtor’s business may be an additional tool for
policing the debtor and its transactions.

12. Where the debtor fails to observe the restrictions and enters into contracts
requiring consent without first obtaining that consent, the insolvency law may
need to address the validity of such transactions and provide appropriate
sanctions for the debtor’s behaviour. While one insolvency law provides, for
example, that in such circumstances the court can discontinue the insolvency
proceedings altogether, the appropriateness of this remedy depends not only
upon whether the proceedings were commenced on the application of the
Part two: III. Participants                                                   165


debtor or creditors (the debtor should not be able to frustrate proceedings
commenced on an application by creditors by failing to observe the insolvency
law or orders of the court), but also upon what is in the best interests of all
parties involved in the proceedings and the availability of other mechanisms
in the insolvency law for addressing that type of behaviour by the debtor
(including the possibility of converting reorganization proceedings to
liquidation).

13. Insolvency laws that enumerate the transactions requiring consent estab-
lish a relatively clear line of responsibility between the debtor and the insol-
vency representative or the court. A number of these laws also provide that the
insolvency representative can take greater control of the insolvency estate and
day-to-day management of the business if required to protect the insolvency
estate in a particular case. Appropriate circumstances may include where there
is evidence of a lack of accountability on the part of the debtor or where there
is mismanagement or misappropriation of assets by the debtor. Where these
circumstances arise, it may be desirable to permit the debtor to be displaced
by the court, on its own motion or on that of the insolvency representative or
perhaps on that of the creditors or creditor committee.

14. Creditors may have a role to play in monitoring the management activities
of the debtor and ensuring that it carries them out effectively. Where creditors
have such a role there may be a need for measures that would prevent possible
abuse by creditors seeking to frustrate the reorganization proceedings or to
gain improper leverage. The required degree of protection could be achieved
by requiring, for example, the vote of an appropriate majority of creditors
before allowing creditors to take action to displace the debtor or increase the
supervisory role of the insolvency representative.

15. A different approach to the delineation of powers between the debtor and
the insolvency representative is one where the insolvency law does not specify
the transactions that the debtor may undertake, but allows the court or the
insolvency representative to determine which legal acts management can per-
form with approval and which it cannot. While allowing some degree of flex-
ibility, this approach may deter debtors from commencing insolvency proceed-
ings as the effect of commencement on management and control of the
business will be unclear.

      c. Full control by the debtor
16. A further approach to the issue of the debtor’s ongoing role is one that
enables the debtor to retain full control over the operation of the business, with
the consequence that the court does not appoint an independent representative
once the proceedings commence (often known as “debtor in possession”).
Where the insolvency law permits a debtor to remain in control of the business,
it is desirable that the functions of an insolvency representative that may be
performed by that debtor in possession are specified. In some circumstances,
that approach may enhance the chances of a successful reorganization by
recognizing the debtor’s familiarity with the business provided it can be relied
166                                                 UNCITRAL Legislative Guide on Insolvency Law


upon to carry on the business in an honest manner and obtain the trust, con-
fidence and cooperation of creditors.

17. There may be, however, disadvantages to this approach, which include it
being used in situations where the outcome is clearly not likely to be successful
or to delay the inevitable with the result that assets continue to be dissipated
and the possibility that the debtor may act irresponsibly and even fraudulently
during the period of control, undermining the reorganization as well as the
confidence of creditors. Some of these difficulties may be mitigated by adopt-
ing certain protections such as a requirement that the debtor report regularly on
the conduct of the proceedings to the court; permitting the court, in certain
circumstances, to appoint an insolvency representative to supervise the debtor;
giving the creditors a significant role in supervising or overseeing the debtor;
or providing for conversion of the proceedings to liquidation.

18. It should be noted that, where this approach is adopted, the management
of the debtor at the commencement of the proceedings is often not the same
management that is charged with implementation of an approved plan and
some of the factors noted above will not be as compelling as they would be
in circumstances where the debtor’s management remains in place throughout
the proceedings. Nevertheless, the debtor-in-possession approach is a complex
one that requires detailed consideration not only because it depends upon
strong corporate governance rules and institutional capacity, but also because
it affects the design of a number of other provisions of an insolvency regime
(e.g. preparation of the reorganization plan, exercise of avoidance powers,
treatment of contracts and obtaining post-commencement finance) that are not
addressed in detail in the Legislative Guide.



                                   3.    Rights of the debtor
19. To preserve what are regarded in some States as fundamental rights of the
debtor and to ensure its fair and impartial treatment, and perhaps more impor-
tantly to encourage debtor confidence in insolvency proceedings, it is desirable
that the role of the debtor in the proceedings and the rights it will have with
respect to the conduct of the proceedings be clearly enumerated in the insol-
vency law. In many States, the rights of a natural person debtor in insolvency
proceedings may be affected by obligations under international and regional
treaties such as the International Covenant on Civil and Political Rights2 and
the European Convention on Human Rights.3

  Right to be heard, to access information and to retain personal property
20. It is desirable, for the reasons indicated above, that the debtor has the right
to be heard in the insolvency proceedings and to participate generally in the

      2
          United Nations, Treaty Series, vol. 999, No. 14668.
      3
          Ibid., vol. 213, No. 2889.
Part two: III. Participants                                                    167


decision-making that is a necessary part of the proceedings, in particular
reorganization proceedings. The debtor should be able to access information
relating to the progress of the proceedings in all cases, but especially where the
insolvency law provides for some level of displacement of the debtor (whether
in liquidation or reorganization) from management and control of the business.
This access to information may be particularly important in reorganization
where the insolvency law provides for some level of displacement before
approval of the plan, but requires the debtor to take responsibility for the plan’s
implementation. It may also be appropriate, in circumstances where the debtor
does not play a role in formulation of the plan, for it to be given an opportunity
to express an opinion on the plan before it is submitted for approval of
creditors. As noted above (chap. II, paras. 18-21), where the debtor is a natural
person, certain assets are generally excluded from the insolvency estate in
order to enable the debtor to preserve its personal rights and those of its family
and it is desirable that the right to retain those excluded assets be made clear
in the insolvency law.

21. There may be situations, however, where the exercise or observance of
these rights leads to formalities and costs that impede the course of the pro-
ceedings, without being of any direct benefit to the debtor. It may be the case,
for example, that where the debtor is no longer present in the jurisdiction in
which the proceedings are being conducted and refuses or fails to respond to
all reasonable attempts by the insolvency representative or the court to estab-
lish contact, an absolute requirement to be heard could seriously impede
progress of the proceedings, if not make them impossible to undertake. Simi-
larly, in cases where the debtor is no longer operational and cannot be heard
as such, or where the equity holders and owners of the business will not
participate in any distribution in the proceedings, an absolute requirement to be
heard may not serve any useful purpose. For these reasons, while it is desirable
to provide that all reasonable efforts to allow the debtor to be heard should be
made, an insolvency law may need to provide some flexibility in exceptional
cases to avoid the requirement to observe the right adversely affecting the
conduct of the proceedings.



                              4.   Obligations of the debtor
22. As noted with respect to the rights of the debtor, it is desirable that the
insolvency law clearly identify the obligations of the debtor with respect to the
insolvency proceedings, including, as far as possible, the content and terms of
the obligations and to whom each obligation is owed. The obligations should
arise on the commencement of the proceedings and continue to apply through-
out the proceedings. These obligations will need to be adjusted to the role to
be played by the debtor in respect of both liquidation and reorganization pro-
ceedings, especially with regard to management and control of the business in
reorganization. For example, where the debtor remains in control of the busi-
ness in reorganization, an obligation to surrender control of the assets of the
insolvency estate will not be applicable.
168                                       UNCITRAL Legislative Guide on Insolvency Law


(a)   Cooperation and assistance
23. To ensure that insolvency proceedings can be conducted effectively and
efficiently, some insolvency laws that provide for some level of displacement
or supervision of the debtor impose on the debtor a general obligation to
cooperate with and assist the insolvency representative in performing its duties
and in some laws to refrain from conduct that might be injurious to the conduct
of the proceedings. An essential part of the obligation to cooperate will be to
enable the insolvency representative to take effective control of the insolvency
estate by the debtor surrendering control of assets, business records and books.
Where the assets of the debtor are located in a foreign jurisdiction, it may not
be possible for the debtor to surrender control of those assets, but the obliga-
tion should refer to facilitating or cooperating with the insolvency representa-
tive in the recovery of those assets located abroad (see the UNCITRAL Model
Law on Cross-Border Insolvency, annex III). The obligation to cooperate may
also require the debtor to assist the insolvency representative to prepare a list
of creditors and their claims, as well as a list of the debtor’s debtors (see
below, para. 49).

(b)   Provision of information
24. To facilitate a thorough, independent assessment of the business activities
of the debtor, including its immediate liquidity needs and the advisability of
obtaining post-commencement financing, the prospects for the long-term sur-
vival of the business and whether management is qualified to continue to lead
the business, information concerning the debtor, its assets and liabilities, finan-
cial position and affairs generally will be required. To enable that assessment
to be undertaken, it is desirable that in both liquidation and reorganization, but
in particular in reorganization and where the business is to be sold as a going
concern in liquidation, the debtor has a continuing obligation to disclose
detailed information regarding its business and financial affairs over a substan-
tial period, not simply the period in proximity to commencement of proceed-
ings. That detailed information may include information concerning assets and
liabilities; income and disbursements; customer lists; projections of profit and
loss; details of cash flow; marketing information; industry trends; information
thought to concern the causes or reasons for the financial situation of the
debtor; disclosure of past transactions that involved the debtor or assets of the
debtor, including those which may be capable of avoidance under the insol-
vency law; and information concerning outstanding contracts, transactions
involving related persons and ongoing court, arbitration or administrative pro-
ceedings against the debtor or in which the debtor is involved. A number of
insolvency laws also require the debtor to provide information concerning its
creditors and, as noted above, to prepare, often in cooperation with the insol-
vency representative, a list of creditors against which claims can be verified,
as well as a list of its debtors. The debtor may also be required to update the
list of claims from time to time as claims are verified and admitted or denied.

25. Although it may not be necessary for an insolvency law to detail exhaus-
tively the information that is to be provided by the debtor, an approach of
Part two: III. Participants                                                      169


listing the type of information required may be useful to provide guidance
and, potentially, to avoid disputes. In that regard, some laws have developed
standardized information forms that set out the specific information required.
These are to be completed by the debtor (with appropriate sanctions for false
or misleading information) or by an independent person or administrator.

26. To ensure that the information provided can be used for the purposes
noted above, it needs to be up to date, complete, accurate and reliable and be
provided as soon as possible after the commencement of the proceedings,
subject to allowing the debtor the time necessary to collect the relevant infor-
mation. Where the debtor can meet this obligation it may serve to enhance the
confidence of creditors in the ability of the debtor to continue managing the
business.

27. The procedure for eliciting the information outlined above may be central
to the ultimate usefulness of that information. If, for example, members of the
management of the debtor are responsible for the debtor’s current financial
situation, they may be unwilling to give full and frank disclosure or to disclose
information that may be self-incriminating (although many criminal laws pro-
vide that self-incriminating evidence may not be used in subsequent criminal
proceedings in order to encourage frank disclosure). Accordingly, in addition
to the debtor’s obligation to provide information, it may be desirable for an
insolvency law to give the insolvency representative and the creditors or the
creditor committee the corresponding right to demand and receive information
from the debtor, with appropriate sanctions where the requested information is
not forthcoming. The debtor’s obligation may be supplemented by additional
measures that include appointing an independent person to examine the debtor
as to its financial affairs or requiring the debtor itself (where it is a natural
person) or one or more of the directors of the debtor to be represented at, or
required to attend, a meeting of creditors to answer questions (except where
this is not physically possible for geographical reasons).


(c)   Confidentiality
28. Often the information to be provided by the debtor or concerning the
debtor will be of a commercially sensitive nature, confidential or subject to
obligations owed to other persons (such as trade secrets, lists of customers and
suppliers, research and development information, professional secrets or privi-
leged or otherwise confidential information) and may belong either to the
debtor or to a third party, but be in the control of the debtor. It is desirable that
an insolvency law include provisions to protect these types of information from
abuse by creditors or other parties who are in a position to take advantage of
it in insolvency. In order to balance the debtor’s obligation of protection
against its obligation to provide information to the insolvency representative,
the court or to creditors, the obligation to observe confidentiality and protect
this information may also need to apply to parties connected to the debtor, the
insolvency representative, creditors generally, creditor committees and third
parties.
170                                      UNCITRAL Legislative Guide on Insolvency Law


(d)   Ancillary obligations
29. A number of insolvency laws impose additional obligations that are
ancillary to the debtor’s obligation to cooperate and assist. These may include
an obligation (applying either to a natural person debtor or the managers and
directors of a legal person debtor) not to leave their habitual place of residence
without the permission of the court or the insolvency representative or to
provide notice to the court or the insolvency representative if they propose or
are forced to leave that residence, to disclose all correspondence to the insol-
vency representative or the court and other limitations touching upon personal
freedom. In the case of a legal person debtor, limitations may also apply to
movement of the headquarters of that legal person and an insolvency law may
require consent of the court or the insolvency representative where such move-
ment is proposed. These limitations may be crucial to avoid disruption to the
insolvency proceedings by the common practice of debtors leaving the place
of business and of directors and managers resigning from office upon com-
mencement. Where they are included in an insolvency law, it is desirable for
these ancillary duties to be proportionate to their underlying purpose and to the
overall purpose of the general duty to cooperate; they may also be limited by
the application of relevant human rights conventions and agreements, as noted
above.

30. Some insolvency laws specify these obligations as automatically applica-
ble, while others provide that they may be ordered at the discretion of the court
where they are determined to be necessary for the administration of the estate.
Some laws also distinguish between natural and legal person debtors; where
the debtor is a natural person, limitations will only apply by order of the court,
but where the debtor is a legal person, some limitations may apply auto-
matically, such as the requirement to disclose correspondence.

(e)   Employment of professionals to assist the debtor
31. To assist the debtor in carrying out its duties in relation to the proceedings
generally, some insolvency laws permit the debtor to employ professionals
such as accountants, attorneys, appraisers and other professionals as may be
necessary, subject to authorization. In some laws that authorization is provided
by the insolvency representative, in others by the court or the creditors.

(f)   Failure to observe obligations
32. Where the debtor fails to comply with its obligations, the insolvency law
may need to consider how that failure should be treated, taking into account
the nature of different obligations and appropriate sanctions. As noted above,
where information is withheld by the debtor, a mechanism to compel the
provision of relevant information such as a “public examination” of the debtor
by the court or the insolvency representative may be appropriate. In more
serious cases of withholding of information a number of States impose criminal
sanctions. Similar approaches may be appropriate for the breach of other
obligations. In reorganization, conversion to liquidation (see chap. IV,
Part two: III. Participants                                                            171


paras. 72-75) may be an appropriate sanction, provided it is in the best interests
of creditors. There will be cases where continuation of the reorganization,
notwithstanding the debtor’s failure to cooperate or to otherwise observe its
obligations, will be in the best interests of creditors.

33. The insolvency law may also need to consider the consequences of
actions taken in violation of the obligations and whether or not those actions
should be invalid. For example, contracts entered into by the debtor after the
commencement of proceedings might be addressed in the context of avoidance
proceedings or as unauthorized transactions. Consideration may also need to be
given to the parties to whom the sanctions should apply in the case of a legal
person debtor, for example, any person who generally might be described as
being in control of the debtor, including directors and management.

                               5.   Debtor’s liability
34. When a business entity is solvent, the owners of the business are its
principal financial stakeholders and relations with creditors will be governed
by their contractual agreements. When the business becomes insolvent, how-
ever, the focus changes and the creditors become the real financial
stakeholders in the business, bearing the risk of any loss suffered as the debtor
continues to trade. Notwithstanding this change of focus, the conduct and
behaviour of owners and management of a business is primarily a matter of
law and policy outside the insolvency regime. It is not desirable that an insol-
vency law be used to remedy defects in that area of legal regulation or to police
corporate governance policies, exhaustively although some insolvency laws
might include an obligation to commence insolvency proceedings at an early
stage of financial difficulty. If the consequence of the past conduct and behav-
iour of persons connected with an insolvent debtor is damage or loss to the
creditors of the debtor (e.g. by fraud or irresponsible behaviour), it may be
appropriate, depending upon the liability regimes applicable for fraud on the
one hand and negligence on the other, for an insolvency law to provide for
possible recovery of the damage or loss from the persons concerned.



                              Recommendations 108-114

     Purpose of legislative provisions
          The purpose of provisions concerning the debtor is:
         (a) To establish the rights and obligations of the debtor during the insol-
     vency proceedings;
          (b) To address the remedies for failure of the debtor to meet its obliga-
     tions; and
         (c) To address issues relating to management of the debtor in insolvency
     proceedings.
172                                                  UNCITRAL Legislative Guide on Insolvency Law




      Recommendations 108-114 (continued)
      Content of legislative provisions
      Rights
             Right to be heard (paras. 20 and 21)
             See recommendation 137.

             Right to participate and request information (para. 20)
           108. The insolvency law should specify that the debtor is entitled to
      participate in the insolvency proceedings, and to obtain information relating to
      those proceedings from the insolvency representative and the court.

             Right to retain property to preserve the personal rights
             of the debtor (para. 20)
          109. Where the debtor is a natural person, the insolvency law should
      specify that the debtor is entitled to retain those assets excluded from the estate
      by the law.4

      Obligations of the debtor (paras. 22-27, 29 and 30)
           110. The insolvency law should clearly specify the debtor’s obligations
      in respect of insolvency proceedings. Those obligations should arise on the
      commencement of, and continue throughout, those proceedings. The obliga-
      tions should include obligations:
           (a) To cooperate with and assist the insolvency representative to perform
      its duties;
            (b) To provide accurate, reliable and complete information relating to its
      financial position and business affairs that might be requested by the court, the
      insolvency representative, creditors and/or the creditor committee, including
      lists of:5
                   (i) Transactions occurring prior to commencement that involved
                       the debtor or the assets of the debtor;
                  (ii) Ongoing court, arbitration or administrative proceedings,
                       including enforcement proceedings;
                 (iii) Assets, liabilities, income and disbursements;
                 (iv) Debtors and their obligations; and
                  (v) Creditors and their claims prepared in cooperation with the
                       insolvency representative and revised and amended by the
                       debtor as claims are verified and admitted or denied;
          (c) To cooperate with the insolvency representative to enable the insol-
      vency representative to take effective control of the estate and to facilitate or



      4
          See chap. II, paras. 17-21 and recommendation 38.
      5
          Subject to allowing the debtor the time necessary to collect the relevant information.
Part two: III. Participants                                                                          173




     cooperate in the recovery by the insolvency representative of the assets, or
     control of the assets of the estate, wherever located6 and business records;
     and
           (d) Where the debtor is a natural person, to provide notice to the court
     if it proposes or is forced to leave its habitual place of residence and, where
     the debtor is a legal person, to obtain the consent of the court or the insolvency
     representative to the movement of its the headquarters.

     Confidentiality (paras. 28, 52 and 115)
         111. The insolvency law should specify protections for information pro-
     vided by the debtor or concerning the debtor7 that is commercially sensitive or
     confidential.

     The debtor’s role in continuation of the business (paras. 2-18)
          112. The insolvency law should specify the role of the debtor in the
     continuing operation of the business during insolvency proceedings. Different
     approaches may be taken, including:
         (a) Retention of full control of the business (debtor in possession), with
     appropriate protections including varying levels of control of the debtor and
     provision for displacement of the debtor in specified circumstances;8
          (b) Limited displacement, where the debtor may continue to operate the
     business on a day-to-day basis, subject to the supervision of an insolvency
     representative, in which event the division of responsibilities between the
     debtor and the insolvency representative should be specified in the law; or
          (c) Total displacement of the debtor from any role in the business and
     the appointment of an insolvency representative.

         113. The insolvency law should specify, where the debtor is a debtor in
     possession, those functions of the insolvency representative that may be per-
     formed by the debtor in possession.

     Sanctions for the debtor’s failure to comply with its obligations
     (paras. 32 and 33)

          114. The insolvency law should permit the imposition of sanctions for
     the debtor’s failure to comply with its obligations under the insolvency law.




      6
        See the UNCITRAL Model Law on Cross-Border Insolvency (annex III).
      7
        Information provided by the debtor may include information in control of the debtor, owned
by the debtor or a third party and information concerning the debtor may be provided by creditors,
financial institutions and others.
      8
        It should be noted that this option relies on a well-developed court structure and the application
of protections that operate to displace the debtor in certain circumstances. (For a more detailed
discussion, see above, paras. 16-18).
174                                       UNCITRAL Legislative Guide on Insolvency Law


                    B.   The insolvency representative
                               1.   Introduction
35. Insolvency laws refer to the person responsible for administering the
insolvency proceedings by a number of different titles, including “admini-
strators”, “trustees”, “liquidators”, “supervisors”, “receivers”, “curators”,
“official” or “judicial managers” or “commissioners”. The term “insolvency
representative” is used in the Guide to refer to the person fulfilling the range
of functions that may be performed in a broad sense without distinguishing
between those different functions in different types of proceeding. The
insolvency representative may be an individual or, in some jurisdictions, a
corporation or other separate legal entity. However appointed, the insolvency
representative plays a central role in the effective and efficient implementation
of an insolvency law, with certain powers over debtors and their assets and a
duty to protect those assets and their value, as well as the interests of creditors
and employees, and to ensure that the law is applied effectively and
impartially. Accordingly, it is essential that the insolvency representative be
appropriately qualified and possess the knowledge, experience and personal
qualities that will ensure not only the effective and efficient conduct of the
proceedings and but also that there is confidence in the insolvency regime.

                              2.    Qualifications
36. The qualifications required of a person who can be appointed as an insol-
vency representative may vary depending upon the design of an insolvency law
with regard to the role of the insolvency representative (including whether the
proceedings are liquidation or reorganization) and the level of supervision of the
insolvency representative (and of the insolvency proceedings generally) by the
court. They may also vary depending upon the procedure for appointment (see
below, paras. 44-47). Where the insolvency law provides for a public official to
be appointed as insolvency representative, the specific qualifications discussed
below will generally not be relevant to that appointment (although they may be
relevant to the employment of the official by the government agency).
37. In determining the qualifications required for appointment as an insol-
vency representative, it is desirable that a balance be achieved between
stringent requirements that lead to the appointment of a highly qualified per-
son, but which may significantly restrict the pool of professionals considered
to be appropriately qualified and add to the costs of the proceedings, and
requirements that are too low to guarantee the quality of the service required.
Where there is a lack of appropriately qualified professionals, the role given
to the court in appointment and supervision of the insolvency representative
may be an important factor in achieving the required balance.

(a)   Interim insolvency representative
38. Where an insolvency representative is appointed on an interim basis by
the court before insolvency proceedings commence, the powers and functions
Part two: III. Participants                                                   175


of that person will generally be determined by the court. To the extent that they
are the same as those of an insolvency representative appointed after com-
mencement of proceedings, the interim insolvency representative should have
the same qualifications, as well as liability and rates of remuneration, as a
representative appointed after commencement.

(b)   Knowledge and experience
39. The complexity of many insolvency proceedings makes it highly desirable
for the insolvency representative to be appropriately qualified, with knowledge
of the law (not only insolvency law, but also relevant commercial, finance and
business law), as well as adequate experience in commercial and financial
matters, including accounting. The insolvency representative will be required
to demonstrate competence in carrying out its assigned functions in a range of
different cases and circumstances that are likely to be contentious, in both
liquidation and reorganization, where time limits may be imposed by the
insolvency law, where commercial requirements have to balanced against legal
considerations and where there is a need to serve the interests of others, such
as creditors and maybe a public interest. If further or more specialized
knowledge is required in a particular case, it can always be provided by hired
experts. Some insolvency laws also require a person to be appointed as an
insolvency representative in a particular case to have expertise and skills suited
to that case, such as knowledge of the debtor’s particular business, its assets
and the type of market in which it operates.

(c)   Ensuring appropriate qualifications
40. Different approaches are taken to ensuring the appropriate qualification of
the insolvency representative, including a requirement for certain professional
qualifications and examinations; licensing where the licensing system is
administered by a government authority or professional body; specialized
training courses and certification examinations; and requirements for certain
levels of experience (generally specified in numbers of years) in relevant areas,
for example, finance, commerce, accounting and law, as well as in the conduct
of insolvency proceedings. There may also be requirements for ongoing pro-
fessional education to ensure familiarity with current developments in relevant
areas of law and practice. Those systems which require some form of licensing
or professional qualification and membership of professional associations often
also address issues of supervision and discipline and an insolvency representa-
tive may be subject to regulation by the court, a professional association, a
corporate regulator or other body under legislation other than the insolvency
law. A number of these systems are relatively complex and it is beyond the
scope of the Legislative Guide to consider them in any detail.

(d)   Personal qualities
41. In addition to having the requisite knowledge and experience, it may also
be desirable for the insolvency representative to possess certain personal quali-
ties, such as integrity, impartiality, independence and good management skills.
176                                      UNCITRAL Legislative Guide on Insolvency Law


Integrity should require that the insolvency representative has a sound reputa-
tion and no criminal record or record of financial wrongdoing or, in some
States, no previous insolvency or removal from a position of public adminis-
tration. The occurrence of such an event would generally be sufficient to
disqualify the proposed appointee from appointment.

(e)    Conflict of interest
42. An essential element of these personal qualities is that the insolvency
representative is able to demonstrate independence from vested interests,
whether of an economic, familial or other nature. To that end, it is desirable
that the insolvency law impose an obligation to disclose existing or potential
conflicts of interest, which would apply to a person proposed for appointment
as an insolvency representative at the commencement of the proceedings and
to the appointed person on a continuing basis throughout the proceedings. The
law should specify to whom the disclosure should be made. This may vary
depending upon the procedure for selection and appointment of the insolvency
representative. The circumstances that amount to a conflict of interest vary
between laws, as do the consequences of a conflict being disclosed at the
commencement of proceedings or discovered at some later stage.

43. A conflict of interest may arise, for example, from a number of prior or
existing relationships with the debtor. Prior ownership of the debtor; a prior or
existing business relationship with the debtor (including being a party to a
transaction with the debtor that may be subject to investigation in the insol-
vency proceedings and being a creditor or debtor of the debtor); a relationship
with a creditor of the debtor; prior engagement as a representative or officer
of the debtor; prior engagement as an auditor of the debtor; and a relationship
with a competitor of the debtor may be sufficient to establish a conflict of
interest. In some States that conflict of interest will preclude the appointment
of the person as an insolvency representative or disqualify an appointee from
continuing in that role. In others, the person may still be appointed, provided
the conflict of interest is disclosed on the basis that the disclosure supports
their integrity and any impartiality or lack of independence can be assessed
against the circumstances disclosed. In order to enhance the transparency,
predictability and integrity of an insolvency regime, it is desirable that an
insolvency law specify the degree of relationship that gives rise to such a
conflict of interest, including specifying those relationships which will dis-
qualify a person from being appointed. It is generally left to the courts to
determine whether or not a conflict of interest or a basis for demonstrating lack
of independence exists in a particular case.


      3.   Selection and appointment of the insolvency representative
44. Insolvency laws adopt a number of different approaches to selection and
appointment of an insolvency representative. The first step involves determin-
ing the pool of potential candidates for appointment. The insolvency repre-
sentative can be selected from a number of different backgrounds such as from
Part two: III. Participants                                                   177


the ranks of the business community, from the employees of a specialized
governmental agency or from a private panel of qualified persons (often
lawyers, accountants or other professionals). In some jurisdictions, the insol-
vency law provides that a particular public official (variously titled the “offi-
cial trustee”, the “official receiver” or the “official assignee”) will automati-
cally be appointed to all insolvency cases or to certain types of insolvency
case. In many States, the insolvency representative must be a natural person,
but some States do provide that a legal person may also be eligible for appoint-
ment, subject to certain requirements such as that the individuals to undertake
the work on behalf of the legal person are appropriately qualified and that the
legal person itself is subject to regulation.

(a)   Court selection and appointment
45. The second step is to determine the procedure for appointing an insol-
vency representative from among the pool of those eligible. In many jurisdic-
tions, it is the court that selects, appoints and supervises the insolvency repre-
sentative. The selection may be made from a list of appropriately qualified
professionals at the discretion of the court; it may be made by reference to a
roster or rotation system; or by some other means, such as the recommendation
of the creditors or the debtor. While ensuring fair and impartial distribution of
cases, one possible disadvantage of a roster system is that it may not ensure
the appointment of the person most qualified to conduct the particular case.
That may depend, of course, upon the manner in which the roster is compiled
and upon the qualifications required of insolvency professionals in order to be
included on that roster and it may not be as important an issue where the estate
does not have sufficient assets to fund the cost of the administration.

(b)   Independent appointing authorities
46. In some jurisdictions, a separate office or institution, which is charged
with the general regulation of all insolvency representatives, selects the insol-
vency representative after the court directs it to do so. This approach may have
the advantage of allowing the independent appointing authority to draw upon
professionals that will have the expertise and knowledge to deal with the
circumstances of a particular case, including the nature of the debtor’s business
or other activities; the type of asset; the market in which the debtor operates
or has operated; the special knowledge required to understand the debtor’s
affairs; or some other special circumstance. The use of an independent appoint-
ing authority will obviously depend upon the existence of an appropriate body
or institution that has both the resources and infrastructure necessary to
perform the required functions or will require the establishment of such body
or institution.

(c)   Role of creditors
47. Another approach allows creditors to play a role in recommending and
selecting the insolvency representative to be appointed, provided that that
person meets the qualifications for serving in the specific case. Both this
approach and the one that relies upon the independent appointing authority
178                                       UNCITRAL Legislative Guide on Insolvency Law


may serve to avoid perceptions of bias and assist in reducing the supervisory
burden placed upon the courts. A different approach permits the debtor to
appoint the insolvency representative in those cases where reorganization pro-
ceedings are commenced by the debtor. This approach allows discussions to
take place between the debtor and other parties, such as secured creditors,
before commencement of the proceedings to familiarize the prospective repre-
sentative with the business and allows the debtor to select an insolvency rep-
resentative that it considers will be best able to conduct the reorganization.
Concerns may be raised, however, as to the independence of an insolvency
representative in those circumstances. These concerns may be addressed by
permitting creditors, in appropriate circumstances, to replace an insolvency
representative appointed by the debtor.

              4.   Oversight of the insolvency representative
48. In addition to the requirements for qualifications and personal qualities
applicable on appointment, oversight of the insolvency representative’s per-
formance of its functions (and its demonstration of the qualities indicated
above) can occur in respect of individual cases through the design of an insol-
vency law and the respective roles assigned to participants. Insolvency laws
adopt a variety of approaches, for example, to the relationship between the
insolvency representative and the court and, in particular, to the delineation of
powers between them, as well as to the role that creditors might play in over-
seeing certain decisions of the insolvency representative and on other issues,
such as remuneration and even removal from office. Since it normally has the
most information regarding the situation of the debtor, the insolvency
representative is often in the best position to make informed decisions about
the conduct of the insolvency proceedings. That does not mean, however, that
the insolvency representative can act as a substitute for the court. Notice may
be required to be given to the court or to creditors before the insolvency
representative takes certain decisions; the insolvency representative may be
required to report to the court and to creditors on a regular basis or in respect
of certain activities; the court generally would be required to adjudicate dis-
putes arising in the conduct of the proceedings; and its approval is often
required at a number of stages during the proceedings. Even in States where
the court plays a more restricted role in insolvency proceedings, there is a limit
to the amount of authority that would normally be conferred upon an
insolvency representative.

       5.   Duties and functions of the insolvency representative
49. Insolvency laws often specify the duties and functions that the insolvency
representative will have to perform in the proceedings and it is important that the
insolvency law provide the insolvency representative with the powers necessary
to carry out those duties and functions efficiently and effectively. The duties and
functions with respect to the administration of the proceedings and preservation
and protection of the estate may generally include those set out below (although
the list is not intended to be exhaustive and in some cases the different functions
Part two: III. Participants                                                   179


will overlap or may not be relevant because of the design of the insolvency law)
and some may be more relevant to liquidation than to reorganization:
      (a) Taking immediate control of the assets comprising the insolvency
estate and the debtor’s business records;
      (b) Representing the insolvency estate;
      (c) Obtaining post-commencement finance;
      (d) Exercising rights for the benefit of the insolvency estate in respect of
court, arbitration or administration proceedings under way;
      (e) Obtaining information concerning the debtor, its assets, liabilities
and past transactions (especially those taking place during the suspect period),
including examining the debtor and any third person having had dealings with
the debtor;
      (f) Taking all steps necessary to protect and preserve the assets of the
insolvency estate and the debtor’s business, including preventing unauthorized
disposal of those assets and exercising avoidance powers;
      (g) Registering rights of the estate (where registration is necessary to
perfect the rights of the estate against bona fide purchasers);
      (h) Appointing and remunerating accountants, attorneys and other pro-
fessionals that may be necessary to assist the insolvency representative in
performing its functions;
      (i) Examining contracts that are not fully performed with a view to
deciding whether to continue performance or reject;
      (j) Dealing with employees and their rights and entitlements, including
pension rights;
      (k) In liquidation, realizing the assets of the insolvency estate;
      (l) Verifying and admitting claims and maintaining an updated list of
claims verified and admitted;
      (m) Periodically providing information to the court and to creditors
detailing the conduct of the proceedings. The information would include, for
example, details of the assets sold during the period in question, the prices
realized, the expenses of sale and such information as the court may require
or the creditor committee may reasonably require; receipts and disbursements;
and assets remaining to be administered;
      (n) Attending meetings of creditors;
      (o) Continuing operation and management of the business in reorganiza-
tion and in liquidation where the business is to be sold as a going concern;
      (p) In reorganization, preparing or assisting to prepare a plan of
reorganization or a report as to why reorganization is not possible (where this
function is to be carried out by the insolvency representative);
      (q) Supervising approval of the reorganization plan and, where required,
the implementation of the plan;
      (r) Distributing the proceeds of realization of the estate in liquidation
and closing the estate promptly, efficiently and in accordance with the best
interests of the various constituencies in the case;
180                                      UNCITRAL Legislative Guide on Insolvency Law


     (s) Submitting a final report and accounting of the insolvency estate’s
administration to the court or the creditors, as required; and
     (t) Any other matters that may be referred to the insolvency representa-
tive by the creditors or the court.

50. In addition to these specific duties and functions, insolvency laws often
impose certain general obligations on the insolvency representative. These may
include an obligation to maximize the value and protect the assets of the
insolvency estate and a duty to get the best price reasonably obtainable on the
sale of assets of the estate.

51. Where reorganization involves a debtor in possession and no insolvency
representative is appointed, many of the functions listed above will be per-
formed by the debtor, with varying degrees of supervision by the court or by
creditors.

                             6.   Confidentiality
52. The need to impose an obligation of confidentiality on the debtor has been
noted above. It may also be appropriate for an insolvency law to impose a duty
of confidentiality on the insolvency representative as much of the information
that will be obtained concerning the debtor’s affairs will be of a commercially
sensitive nature, confidential or subject to obligations owed to other persons
(such as trade secrets, research and development information and customer
information) and should not be disclosed to third parties who may be in a
position to take unfair advantage of it. Where the information is to be disclosed
to creditors, those creditors should be under the same obligation of confiden-
tiality as the insolvency representative. Observation of confidentiality may be
particularly important where the insolvency representative has the power to
compel disclosure of information and documents in the course of an examina-
tion of the debtor. Some of this information may come from third parties and
be subject to privacy protection provisions and secrecy provisions, such as
those applicable to banks. It is desirable that the insolvency representative be
permitted to use that information only for the purposes of the insolvency
proceedings in the context of which the examination was permitted, unless the
court decides otherwise. This issue may also be relevant to the provision and
obtaining of information in the context of criminal proceedings against the
debtor. A similar obligation of confidentiality should apply to agents and
employees of the insolvency representative (see below, para. 66) and to other
parties as ordered by the court (including creditors, see below, para. 115).


           7.   Remuneration of the insolvency representative

(a)   Determination of quantum
53. In addition to the reimbursement of the proper expenses incurred in the
course of administration of the estate, the insolvency representative will be
Part two: III. Participants                                                    181


entitled to receive remuneration for its services. That remuneration should be
commensurate with the qualifications of the insolvency representative and the
tasks it is required to perform and should achieve a balance between risk and
reward in order to attract appropriately qualified professionals. Several
methods are adopted for calculating that remuneration. It may be fixed by
reference to an approved scale of fees set by a government agency or profes-
sional association; determined by the general body of creditors, the court or
some other administrative body or tribunal in a particular case; based upon the
time properly spent by the insolvency representative (and the various cate-
gories of person who are likely to work on the insolvency administration from
office staff through to the principal appointee) on administration of the estate;
or it could be based upon a percentage of the quantum of the assets of the
estate that are realized or distributed or a combination of both (calculated at the
end of the procedure when the assets have been sold and the value deter-
mined). This may be a fixed percentage and include provision for increase or
decrease depending upon the particular case. In each of these cases, the insol-
vency law generally makes provision for further investigation upon the appli-
cation either of a party in interest or the insolvency representative itself,
depending upon the method of calculation. Such an approach will be important
to ensure transparency. At the same time, however, it is important to avoid a
situation where the party with the right of final determination can influence the
conduct of the proceedings.


   (i)   Time-based systems
54. An advantage of a time-based method is that often there will be a high
level of uncertainty at the outset as to how complex and resource-intensive a
particular administration may be, at least until some preliminary work has been
carried out. A disadvantage is that, although it may encourage a very thorough
administration, a time-based system may also operate in some cases as an
incentive to maximize the time spent on administration without necessarily
achieving a proportional return of value to the estate.


   (ii) Commission-based systems
55. An advantage of the commission system, at least from the creditors’ per-
spective, is that at least some, if not a substantial proportion, of the assets
recovered will be distributed to them. From the insolvency representative’s
point of view, however, it may be an uncertain method of calculation because
the amount of work involved in an administration is not necessarily propor-
tional to the value of assets available for distribution. It may also encourage
an approach of “maximum return for minimum cost” and provides little incen-
tive for undertaking functions that are not directly related to increasing returns
to creditors, such as obligations to report to both the court and to creditors and
to assist regulatory authorities with investigations into the debtor’s affairs and
possible misconduct. This method of calculation may also lead, in very large
cases, to significantly large fees being paid out of the estate, which can deter
both creditor and debtor applications.
182                                      UNCITRAL Legislative Guide on Insolvency Law


  (iii) Involvement of creditors
56. In some States, the creditors (or the creditor committee) may be required
to play a role in fixing or approving the remuneration, having regard to factors
such as the complexity of the case, the nature and degree of the responsibilities
of the insolvency representative and the effectiveness with which these have
been discharged, as well as the value and nature of the assets of the estate. The
involvement of creditors may serve to overcome some of the difficulties dis-
cussed above as creditors would be more aware of the issues involved and
have the opportunity to participate in remuneration setting and approval.
Remuneration could also be reviewed periodically during the course of the
proceedings, with any problems being addressed and resolved as they arise,
perhaps by arbitration or some other form of dispute resolution between the
insolvency representative and the creditors. Care should be taken to avoid a
situation where the right of final determination enables one party to unduly
influence conduct of the proceedings.

57. It is highly desirable that the insolvency law establish a mechanism for
fixing the insolvency representative’s remuneration that is clear and trans-
parent enough to avoid disputes and to provide some level of certainty as to
the costs of insolvency proceedings. However calculated, it is also desirable
that an insolvency law recognize the importance of according priority to
payment of the insolvency representative’s remuneration.



(b)   Means of payment
58. Payment of the remuneration of the insolvency representative is often a
source of complaint from unsecured creditors; the most common source of
available funds is often unencumbered assets and payment of the remuneration
may result in nothing being left for distribution to those creditors. While it
would be unfair to draw the conclusion that the costs of administration were
excessive simply because they exceeded the value of the unencumbered assets
available to pay them, the occurrence of unsecured creditors seeing most if not
all of the available assets being used to cover the costs of the administration
and perceptions of unfairness relating to the total cost of administration
compared to the value of assets recovered do point to the need to give this
issue careful consideration. Different approaches can be taken to payment of
the insolvency representative. For example, where they are included in the
insolvency estate, remuneration could be paid from unencumbered assets; a
surcharge could be levied against assets to pay for the administration or sale
of those assets where the administration or sale would be of benefit to the
creditors; a surcharge also could be levied on creditors making an application
to commence insolvency proceedings to cover at least initial costs and
performance of basic administration functions; or encumbered assets may be
subject to payment of a proportionate or defined share of remuneration.
Another approach is to pay the insolvency representative from a fund main-
tained for that purpose by the State, an approach that may be particularly
Part two: III. Participants                                                                     183


relevant in the case of debtors with insufficient assets to pay for administration
of the estate (see chap. I, paras. 72-75).9

(c)    Review of remuneration
59. Depending upon the manner in which the insolvency representative’s
remuneration is fixed, it may be desirable to provide a review procedure to
address dissatisfaction of the insolvency representative itself or of creditors.
Where remuneration is fixed by a meeting of creditors, the court will generally
have the power to review the amount on the application of the insolvency
representative or of a specified percentage or number of creditors, for example,
creditors representing 10 per cent of the issued share capital or with at least
10 per cent or 25 per cent of the total debts. Where the remuneration is set by
the court in the first instance, different approaches are taken; some laws permit
the insolvency representative to appeal that decision, other laws do not. Some
insolvency laws also provide that the debtor cannot make an application for
review. Where the insolvency representative is required to be a member of a
professional organization or to be licensed, the professional organization or the
licensing authority may also have powers with respect to review of the fees
charged by their members and may provide informal dispute resolution
mechanisms.

                  8. Liability of the insolvency representative
60. The standard of care to be employed by the insolvency representative and
its personal liability are important to the conduct of insolvency proceedings.
Establishing a measure for the care, diligence and skill with which the insol-
vency representative is to carry out its duties and functions requires that the
difficult circumstances in which the insolvency representative finds itself when
fulfilling its role are taken into account and balanced against payment of an
appropriate level of remuneration and the need to attract qualified persons to
act as insolvency representatives. A balance is also desirable between a stand-
ard that will ensure competent performance of the duties of the insolvency
representative and one that is so stringent it invites law suits against the insol-
vency representative and raises the costs of its services. An insolvency law will
also need to take into consideration the fact that the liability of the insolvency
representative may often involve the application of law outside insolvency or,
where the insolvency representative is a member of a professional organiza-
tion, the relevant professional standards of the organization.

61. Under many legal systems, the insolvency representative will be liable in
a civil action for damages arising from its misfeasance or malfeasance,
although different approaches are taken to setting the standard required. To
some extent, the measure adopted will depend upon the how the insolvency

       9
         Such a fund may be financed by a number of means, for example, payments by the directors
of debtors being liquidated; increased filing fees for insolvency applications; requiring all monies
realized in liquidation to be deposited into a common account, with interest going to the fund; or
imposing a levy on lodgement of annual corporate returns.
184                                       UNCITRAL Legislative Guide on Insolvency Law


representative is appointed and the nature of the appointment (e.g. a private
practitioner as opposed to a government employee). One approach may be to
require the insolvency representative to observe a standard no more stringent
than would be expected to apply to the debtor in undertaking its normal busi-
ness activities in a state of solvency, that of a prudent person in that position.
Some States, however, may require a higher standard of prudence in such a
case because the insolvency representative is not dealing with its own assets,
but with assets belonging to another person. A different formulation is one
based upon an expectation that the insolvency representative act in good faith
for proper purposes. A further approach may be based upon the standard of
care required to determine negligence.

62. One means of addressing the issue of liability for damages may be to
require the insolvency representative to post a bond or take out insurance to
cover loss of assets of the estate or possible damages payable as a result of a
breach of its duties. A number of insolvency laws require both payment of a
bond and insurance where the bond will cover one kind of damage and the
insurance another, while others require only insurance. In some cases the level
of the bond required relates to the book value of the assets of the insolvency
estate. In others, both the value of the bond and the amount of insurance cover
required are established in the rules of the relevant professional association or
regulatory body or even in the insolvency law. A further distinction between
the two approaches may relate to the procedure for making a claim for
damages and whether it is different for claiming against a bond or against
insurance. Paying a bond or obtaining personal indemnity insurance, however,
may not be possible in all States and other solutions will be needed. In design-
ing the solution to this issue, a balance may be desirable between controlling
the costs of the service provided by insolvency representatives and distributing
the risks of the insolvency proceedings among the participants, rather than
placing it entirely upon the insolvency representative on the basis of avail-
ability of personal indemnity insurance.

63. Another issue of liability is whether the insolvency representative will be
personally liable for obligations incurred in the ordinary course of insolvency
proceedings, in particular in reorganization, such as those relating to the
ongoing operation of the business. The advantages of adopting an approach
that makes the insolvency representative personally liable would be that it
creates certainty for suppliers to the debtor and may operate as a check to the
incurring of debt. At the same time, however, it may also operate as a dis-
incentive if the risk of personal liability far exceeds the fees that may be
earned. One solution is to make only the assets of the estate liable, rather than
the personal assets of the insolvency representative.

64. A further issue of liability relates to liability of the insolvency representa-
tive for wrongful acts of the debtor, which may depend upon the level of
control the insolvency representative exercises over the debtor’s activities.
Under some laws, the insolvency representative may be made liable for the
wrongful acts of the debtor during the period of its control, but it is not
desirable that the insolvency representative be liable for acts of the debtor,
Part two: III. Participants                                                   185


such as environmental damage, occurring prior to its appointment as
insolvency representative.

65. Where an action is commenced against the insolvency representative in its
official capacity, consideration may need to be given to determining which
court will have jurisdiction over the action. To avoid uncertainty and confu-
sion, it may be desirable to ensure that it is the same court that appointed the
insolvency representative (where the court plays a role in such appointments).

       9.    Agents and employees of the insolvency representative
66. Some insolvency laws require court authorization for the insolvency rep-
resentative to retain accountants, attorneys, appraisers and other professionals
that may be necessary to assist the insolvency representative in carrying out its
duties. Other laws do not require court authorization. It is desirable that an
insolvency law establish some criteria relating to the employment of such
professionals in terms of their experience, knowledge and reputation, as well
as the need for their services to be of benefit to the estate. The requirements
for disclosure of conflicts of interest or circumstance giving rise to a lack of
independence that apply to the insolvency representative are also relevant to
professionals employed or proposed for employment by the insolvency repre-
sentative, as are obligations of confidentiality.

(a)   Liability for acts or omissions
67. Where losses are sustained by the estate as a result of the actions of agents
and employees of the insolvency representative, an insolvency law may need
to address the liability of the insolvency representative for those actions. Some
insolvency laws provide that the insolvency representative is not personally
liable except where it fails to exercise the proper degree of supervision in the
performance of its duties.

(b)   Remuneration
68. Different approaches may be adopted towards payment of the professio-
nals employed by the insolvency representative. Some laws require an appli-
cation to and approval by the court of the amount of the remuneration, while
another approach may be to require approval by creditors. Professionals may
be paid periodically during the proceedings or may be required to wait until the
proceedings are completed. In terms of how they are to be paid, some insol-
vency laws provide that the insolvency representative will pay the professional
and seek reimbursement from the estate, while under other laws the profes-
sional will have an administrative claim against the estate.

      10.    Review of the insolvency representative’s administration
69. The grounds upon which creditors may question either the decisions or
administration of an insolvency representative and the decisions that may be
186                                       UNCITRAL Legislative Guide on Insolvency Law


subject to such questioning should be expressly stated in an insolvency law.
The grounds for creditor action under existing laws can be divided into two
main categories.

70. In the first category are those laws under which creditors are given certain
rights where the insolvency representative can be shown to have committed
some wrong. That wrong may include actual wrongdoing, such as the mis-
appropriation of funds or assets or obtaining creditors’ approval by improper
means; procedural errors, such as a failure to seek a necessary approval of
creditors or a creditor committee or to undertake another act required by law;
or negligence by the insolvency representative in the performance of its duties.
Some jurisdictions limit a creditor’s right to challenge the insolvency repre-
sentative to some, if not all, of these situations.

71. In the second category are those laws which provide, normally in addition
to the grounds related to specific wrongdoing, that creditors can test (typically
in the courts) any decision, act or omission of the insolvency representative
that they individually or collectively object to or disapprove of. The basis of
a successful action will normally be grounds similar to those already men-
tioned above, but may also include proof that the decision, act or omission was
contrary to the interests of creditors. To prevent unreasonable disruption of the
administration of an estate, an insolvency law may adopt appropriate limita-
tions, such as adjusting the standard of proof to be met in order for the court
to uphold the creditors’ appeal or protecting certain aspects of an administra-
tion against appeal.

72. Most laws provide the courts, in reviewing an insolvency administration
and enforcing the substantive rights of creditors, with a number of powers. At
one level, a court may direct an insolvency representative to take, or refrain
from taking, a particular action related to the creditor’s objection. The court
may also have powers to confirm, reverse or modify decisions of the insol-
vency representative or to remove the insolvency representative, whether at the
direct request of the objecting creditor or on the motion of the court. Many
insolvency laws provide that the insolvency representative is personally liable
for damages intentionally or negligently caused to creditors through the
performance of its duties. Some insolvency laws also provide that in those
circumstances the court may impose a monetary penalty on the insolvency
representative.



              11.   Removal of the insolvency representative
73. Some insolvency laws permit the insolvency representative to be removed
in certain circumstances. These may include that the insolvency representative
had violated or failed to comply with its legal duties under the insolvency law;
had demonstrated gross incompetence or gross negligence; had not disclosed
a conflict of interest; had engaged in illegal conduct; or for less serious reasons
such as that the proceedings require a particular or different competency that
Part two: III. Participants                                                        187


the appointed representative does not possess. The latter may occur, for
example, where the proceedings are converted from liquidation to reorganiza-
tion, which requires skills the insolvency representative may not have or, in the
case of a debtor-in-possession reorganization, which do not require an insol-
vency representative to be appointed. Different approaches provide that
removal may occur on the basis of a decision of the court, acting on its own
motion or at the request of a party in interest, or a decision taken by an
appropriate majority of unsecured creditors. Whichever approach is adopted,
removal operates as a sanction against the insolvency representative and it is
therefore appropriate that the insolvency representative have the right to be
heard and to present its case. In cases where the insolvency representative is
subject to professional or regulatory supervision, it may be removed as the
result of an investigation and review, which may also result in a licence or
other authorization being taken away.


             12.    Replacement of the insolvency representative
74. In the event of the resignation or removal of the insolvency representative
or the occurrence of any other event that might cause the insolvency repre-
sentative to be unable to perform its duties, such as death or serious illness,
disruption and delay of the proceedings may be avoided by providing a suc-
cessor insolvency representative to be appointed, either by the court or by
creditors. Some insolvency laws require the courts also to approve the resig-
nation of the insolvency representative, while other laws do not. Where an
insolvency law provides for replacement of the insolvency representative, it
may also need to address issues relating to substitution and succession to either
title or control (as appropriate) of the assets of the estate, as well as handing
over to the successor the books, records and other information relating to the
debtor. An insolvency law may also need to consider the issue of the validity
of the acts undertaken in the conduct of the proceedings by the insolvency
representative that has been replaced and remuneration for work undertaken
during the appointment.




                              Recommendations 115-125

     Purpose of legislative provisions

          The purpose of provisions concerning the insolvency representative is:
          (a) To specify qualifications required for appointment;
          (b) To establish a mechanism for selection and appointment;
          (c) To specify powers and functions; and
          (d) To provide for remuneration, liability, removal and replacement.
188                                             UNCITRAL Legislative Guide on Insolvency Law




      Recommendations 115-125 (continued)
      Contents of legislative provisions
      Qualifications (paras. 36-41)
           115. The insolvency law should specify the qualifications and qualities
      required for appointment as an insolvency representative, including integrity,
      independence, impartiality, requisite knowledge of relevant commercial law
      and experience in commercial and business matters. The insolvency law
      should also specify the grounds upon which a proposed insolvency representa-
      tive may be disqualified from appointment.

      Conflict of interest (paras. 42 and 43)
           116. The insolvency law should require the disclosure of a conflict of
      interest, a lack of independence or circumstances that may lead to a conflict
      of interest or lack of independence by:
           (a) A person proposed for appointment as an insolvency representative
      or a person appointed as an insolvency representative where the conflict of
      interest or the circumstances that may lead to a conflict of interest or lack of
      independence arise in the course of insolvency proceedings; and
           (b) Persons proposed for employment by the insolvency representative or
      the estate, including professionals or a person employed by the insolvency
      representative or the estate, where the conflict of interest or the circumstances
      that may lead to a conflict of interest or lack of independence arise in the
      course of insolvency proceedings.
           117. The insolvency law should specify that the obligation to disclose
      set forth in recommendation 116 should continue throughout the insolvency
      proceedings. The insolvency law should specify the consequences of a conflict
      of interest or lack of independence.

      Appointment (paras. 44-47)
           118. The insolvency law should establish a mechanism for selection and
      appointment of an insolvency representative. Different approaches may be
      taken, including appointment by the court; by an independent appointing au-
      thority; on the basis of a recommendation by creditors or the creditor commit-
      tee; by the debtor; or by operation of insolvency law, where the insolvency
      representative is a government or administrative agency or official.

      Remuneration (paras. 53-59)
          119. The insolvency law should establish a mechanism for fixing the
      remuneration of the insolvency representative and establish priority for pay-
      ment of that remuneration.

      Duties and functions of the insolvency representative (para. 49)
           120. The insolvency law should specify that the insolvency repre-
      sentative has an obligation to protect and preserve the assets of the estate.
      The insolvency law should specify the insolvency representative’s duties and
Part two: III. Participants                                                              189




     functions with respect to the administration of the proceedings and preserva-
     tion and protection of the estate, including continued operation of the debtor’s
     business.

     Right to be heard (para. 116)
           See recommendation 137.

     Confidentiality (paras. 28, 52 and 115)
           See recommendation 111.

     Liability (paras. 60-65)
         121. The insolvency law should specify the consequences of the insol-
     vency representative’s failure to perform, or to properly perform, its duties and
     functions under the law and any related standard of liability imposed.

     Removal and replacement (paras. 73 and 74)
         122. The insolvency law should establish the grounds and procedure for
     removal of the insolvency representative. The grounds may include:
         (a) Incompetence, failure to perform or failure to exercise the proper
     degree of care in the performance of its powers and functions;
           (b) Inability to perform;
          (c) Lack of a particular or specialized qualification required by a specific
     case;
           (d) Engaging in illegal acts or conduct;
         (e) Conflict of interest or a lack of independence that would justify
     removal; or
           (f) Where the function of the insolvency representative changes.10
          123. The insolvency law should establish a mechanism for removal of
     the insolvency representative that reflects the manner in which the insolvency
     representative was appointed and provides a right for the insolvency repre-
     sentative to be heard.
          124. In the event of the death, resignation or removal of the insolvency
     representative, the insolvency law should establish a mechanism for appoint-
     ment of a replacement and specify whether or not court approval of the
     replacement is necessary.

     Estates with insufficient assets to meet the costs of administration
     (para. 45 and chap. I, paras. 72-75)
          125. Where the insolvency law provides for an insolvency representative
     to be appointed to administer an estate with insufficient assets to meet the
     costs of administration, the insolvency law should also establish a mechanism
     for appointment and remuneration of that representative.


      10
       Such as where the proceedings are converted from liquidation to reorganization.
190                                      UNCITRAL Legislative Guide on Insolvency Law


       C.   Creditors: participation in insolvency proceedings
                               1.   Introduction
75. Creditors have a significant interest in the debtor’s business once insol-
vency proceedings are commenced. As a general proposition, many insolvency
laws provide that such interests are safeguarded by the appointment of an
insolvency representative. For a number of different reasons, many insolvency
laws facilitate direct creditor involvement in the proceedings. As the party with
the primary economic stake in the outcome of the proceedings, creditors may
lose confidence in proceedings where key decisions are made without consult-
ing them by individuals who may be perceived by creditors as having limited
experience or expertise in the debtor’s type of business or a lack of independ-
ence, depending upon the manner in which the representative is appointed.
Creditors are often in a good position to provide advice and assistance with
respect to the debtor’s business and to monitor the actions of the insolvency
representative, providing a check against possible abuse of insolvency pro-
ceedings and excessive administrative costs, as well as a means of processing
and distributing information. The desirability of facilitating high levels of
creditor participation must be balanced against the need to ensure that the
creditor representation mechanism remains efficient and cost-effective and
avoids creditors involving themselves in matters that will not have an impact
on their interests (although often it may be difficult to draw a clear distinction
between those matters which do have such an impact and those which do not).

76. Where the insolvency law facilitates creditor participation in the proceed-
ings, that participation may take different forms. Under some laws it includes
only the right to be heard and to appear in the proceedings, while under others
it also includes the right to vote on specified matters, to provide advice to the
insolvency representative as requested or on matters specified in the insol-
vency law, and other functions and duties as determined by the insolvency law,
the courts or the insolvency representative.


       2.   Extent of involvement of creditors in decision-making
(a)   Functions to be performed by creditors
77. There are varying degrees of possible creditor involvement in decision-
making in insolvency proceedings, based upon the functions it is determined
should be performed by creditors. In general, a determination as to which
functions should be given to creditors involves a consideration of the overall
design of the insolvency law and the balance to be achieved between the roles
of the court, the insolvency representative, the debtor and creditors, in particu-
lar in terms of oversight and supervision. To some extent, the different func-
tions given to creditors reflect different insolvency cultures and traditions and,
in particular, different expectations on the part of creditors as to the level of
their participation in insolvency proceedings. However, creditor participation is
increasingly regarded as an important element of an insolvency law, especially
Part two: III. Participants                                                   191


as a counter-balance to the roles assigned to other participants under the law
and as an important means of safeguarding creditor interests.
78. One approach allows creditors only a low level of participation. Under
such insolvency laws, the insolvency representative is required to make all key
decisions on uncontested general matters of administration, with creditors play-
ing a marginal role and having little influence. A low level of creditor partici-
pation in this model may be balanced against the key obligations of the insol-
vency representative, one of which is to protect the value of the insolvency
estate, ultimately for the benefit of creditors generally. Such an approach may
be effective where an experienced insolvency representative is appointed to the
proceedings, because it avoids potential delays and the costs involved in
managing the participation of creditors, and where the insolvency system pro-
vides a high level of regulation of the proceedings and its participants.
79. Other approaches afford creditors greater participation in the proceedings.
Such participation may range from participation at an initial meeting where
certain matters are considered, to an ongoing role, which may require creditors
to perform an advisory function or, at a higher level, to approve certain acts
and decisions of the insolvency representative. Where creditors perform a
general advisory function, for example, the insolvency representative may refer
matters to the creditors, but will not be bound by any decision they take or
advice they give. Where the insolvency representative is not bound to follow
the decision of creditors, insolvency laws often provide that for certain acts the
insolvency representative must seek the prior approval of the court or that
creditors may apply to the court to give binding instructions to the insolvency
representative (or to seek replacement of the insolvency representative where
the insolvency representative fails to meet its obligations or otherwise acts to
the detriment of creditors).
80. Under other laws, the creditors may have specific functions to perform
with regard to the conduct of the proceedings, which may involve cooperation
and coordination with the insolvency representative. The insolvency repre-
sentative may be required to consult with creditors on those matters before
taking its decision or, alternatively, the decision-making power may reside
with creditors. Other functions require the creditors to oversee the acts and
decisions of the insolvency representative. These acts and decisions generally
involve administration of the proceedings and issues that affect the interests of
creditors. They may include the sale of assets outside the ordinary course of
business; verification of claims; approval of administrative expenses; continu-
ation of the business in liquidation; post-commencement financing; compensa-
tion of professionals, including the insolvency representative; treatment of
judicial proceedings to which the debtor was a party at the time of commence-
ment; consideration and approval of a reorganization plan; appointment of a
committee or representatives of creditors; supervision of acts of the insolvency
representative; distribution of assets; and consideration (and approval) of the
insolvency representative’s final report and accounting.
81. Creditors may have functions with respect to selection and appointment
of the insolvency representative, as well as being able to seek the dismissal and
192                                       UNCITRAL Legislative Guide on Insolvency Law


replacement of the insolvency representative by the court for failure to perform
its functions and duties or for negligence. Creditors may also have a role in
requesting or recommending action by the court, for example, that the
reorganization be converted to liquidation or that avoidance proceedings be
commenced by the insolvency representative or by creditors on behalf of the
estate.

82. Where the regime provides for the actions or decisions of the insolvency
representative to be supervised or approved by creditors generally, the creditor
committee or other creditor representative, a high level of creditor protection
may ensue. Where that supervision or approval adds steps to the administration
of the insolvency estate, however, it has the potential to affect the cost and
efficiency of the administrative process. Some level of disagreement between
the insolvency representative and individual creditors is almost impossible to
avoid, in particular as the insolvency representative will be required to act for
the benefit of all creditors and to take action that individual creditors may not
support or agree with. In the normal course of events, however, such dis-
satisfaction would not give the court cause to replace the insolvency repre-
sentative or give the creditor grounds for an action against the insolvency
representative. For these reasons an insolvency regime will need to balance the
extent to which supervision or approval by creditors is required (including
defining both the acts and decisions that require approval and the procedure for
obtaining that approval) against the independence of the insolvency representa-
tive and the desirability of speed and cost-effectiveness in the conduct of the
insolvency proceedings. Regimes vary in the accommodation reached between
these possibly competing factors.

83. Whatever functions are to be performed by the creditors, it is desirable
that an insolvency law clearly state whether creditors are required to undertake
each of the specified functions, or whether certain functions are discretionary,
and the manner in which creditors are to interact with the insolvency repre-
sentative in the performance of those functions. In particular, it may be
desirable to address disputes between the insolvency representative and credi-
tors. Where the dispute involves a matter that falls within the functions to be
performed by a creditor meeting, many laws give precedence to decisions
taken by creditors. Where the insolvency law provides creditors with the power
to object to acts or decisions of the insolvency representative, the course of
action available to creditors where the insolvency representative does not agree
with or accept such an objection and the applicable procedural and evidential
requirements should be specified in the insolvency law.

(b)   Participation in liquidation and reorganization
84. Some insolvency laws draw a distinction between liquidation and reor-
ganization in setting the level of creditor participation. In liquidation, although
generally it may not be important for creditors to intervene in the proceedings
or participate in decision-making, they can provide a valuable source of expert
advice and information on the debtor’s business, in particular where it is to be
sold as a going concern. It may also be desirable for creditors to receive reports
Part two: III. Participants                                                   193


on the conduct of the liquidation to ensure their confidence in the proceedings,
as well as its transparency. In reorganization, however, requiring the input of
creditors is both useful and necessary, as it is creditors that generally will be
asked to approve a proposed reorganization plan.

(c)   Encouraging creditor participation
85. An important issue that may need to be considered where an insolvency
law allows creditors to play an active role in the proceedings is how to over-
come creditor apathy and encourage participation. It is not uncommon for
creditors to adopt the view that, even where the insolvency law provides for
active participation, nothing will be gained from such participation, especially
where the return to creditors is unlikely to be significant and where participa-
tion may in fact require further expenditure of time and money. This common
concern can be addressed to some extent by the overall balance that an insol-
vency law strikes between the different interests of the parties involved in the
proceedings (for example, see above, paras. 2-18) and by specific measures
relating, for example, to selection of the creditor committee and the functions
it is to perform (or by creditors generally where there is no committee), as well
as use of electronic means to facilitate communication and voting where
required. A further concern may relate to possible liability for participating in
the proceedings, especially as a member of a creditor committee. This concern
can be addressed by providing immunity from liability except in clearly
defined circumstances, such as fraudulent or wilful behaviour.

(d)   Need for information and notice
86. It will be essential, in order to enable creditors to perform specific func-
tions, that they be provided, either directly or through a creditor committee or
other form of creditor representation, with relevant, current and accurate infor-
mation on the debtor’s business and financial affairs, and with notice of issues
that affect their interests and on which they may be required to decide or
advise. That notice may be provided through a creditor committee or other
representative. Issues of confidentiality, as noted above with respect to the
debtor and the insolvency representative, will also be relevant to creditors or
the creditor committee where they are provided with such information (see
below, para. 115).

(e)   Secured creditors
87. It is desirable that an insolvency law determine the extent to which se-
cured creditors can or should participate at meetings of creditors or in a credi-
tor committee. As a general rule, secured creditors are not represented on a
creditor committee if they are fully secured or over-secured. In such cases,
their interests are significantly different from those of unsecured creditors and
their ability to participate in and potentially alter the outcome of decisions by
creditors may not be in the best interests of all creditors. Recognizing this
divergence of interests, some insolvency laws require secured creditors to
surrender their security interest before they can participate in the proceedings
194                                       UNCITRAL Legislative Guide on Insolvency Law


and vote on matters requiring a creditor vote. Where they are under-secured,
however, their interests are more likely to align with those of unsecured credi-
tors and their participation in the committee or in voting by creditors may be
appropriate, at least to the extent that they are under-secured. In reorganization,
secured creditors will have a direct interest where their rights may be modified
by a reorganization plan or where the encumbered asset will be key to the
successful implementation of the plan (see chap. IV, paras. 34-39).


                3.   Mechanisms to facilitate participation
88. In terms of the mechanisms for participation, some insolvency laws pro-
vide for full meetings of creditors to be convened at key points in the proceed-
ings. Other laws permit the formation of a committee, on which creditors
sometimes may share representation with equity holders and possibly other
parties in interest, comprising a smaller number of creditors (which number
may be specified in the insolvency law) to facilitate the participation in the
administration of the estate. The former approach is most useful in cases with
small numbers of creditors or where creditors are located in the same geo-
graphical region. The latter may be more useful where there are large numbers
of creditors or creditors are located in different regions or even different
countries. The mechanism used for participation will also depend upon the
immediate issue before creditors. Many insolvency laws include both of these
approaches, with significant issues, such as approval of a reorganization plan,
to be considered by meetings of creditors (see below, para. 96). Where a
committee is appointed it should have the right to act independently of the
insolvency representative in order to ensure fair and unbiased representation of
creditors’ interests.

89. An alternative to formation of a creditor committee is the appointment
(whether by creditors or by the court at the request of creditors) of a single
person (in some laws referred to as an intervenor or inspector) to represent
certain creditors or groups of creditors (e.g. those holding at least 10 per cent
of the debt) in the insolvency proceedings. In one law where this approach has
been adopted the rationale was to facilitate more orderly and timely participa-
tion by creditors and to avoid the delays and disputes that had previously been
encountered. The representative fulfils a role analogous to that of the creditor
committee, acting on behalf of all the creditors it represents to undertake
functions such as monitoring the administration of the estate by the insolvency
representative or the debtor; requesting hearings; bringing actions against the
debtor; requesting provision of information on issues affecting the creditors’
interests; or calling for meetings of creditors. Under some laws, creditors are
required to cover the fees of their representative in order to avoid excessive
charges to the estate, while under others those fees are to be paid by the estate.

90. The choice between these different approaches may involve balancing
factors such as time, cost, efficiency, transparency and democracy. The
approach of appointing a representative, for example, may be more efficient
and cost-effective and lead to more orderly proceedings with fewer disputes
Part two: III. Participants                                                   195


than the creditor committee approach. The latter approach, however, may be
a more transparent and democratic means of representing creditor interests. A
further relevant factor may be the availability of well-trained insolvency pro-
fessionals and effective institutional infrastructure to assist the administration
and conduct of insolvency proceedings. In some cases, a scarcity of profes-
sionals or a weak institutional capacity may be assisted by according creditors
a greater role in the proceedings. Where the conditions in an insolvency regime
support its existence, the most effective arrangement for facilitating creditor
participation may be the creditor committee.

                              4.   Creditor meetings
91. Many insolvency laws provide that the functions allocated to creditors
should be performed at general meetings of creditors. As noted above (see
chap. I, paras. 64-66 and 69-71), an insolvency law should require creditors to
be notified (whether by personal notice, advertisement or some other means)
of the commencement of insolvency proceedings and for that notification to
include advice on a number of matters, including details of an initial meeting
of creditors to be convened by the court or the insolvency representative within
a prescribed period of time after commencement (examples of time limits
included in insolvency laws range from five days to one month from the
effective date of commencement). Under a number of insolvency laws, that
initial meeting is the only meeting of all creditors that takes place. Where such
a meeting is to be convened, it is desirable that the insolvency law specifies
the matters to be discussed and resolved at that meeting.
92. Where the insolvency law provides for other meetings of creditors to be
held, different approaches are taken. Under some laws, those other meetings
are to be convened by the court or the insolvency representative for specific
purposes, while other laws include provision for creditors or the insolvency
representative, and in some limited cases the debtor, to convene meetings on
an ad hoc basis, as required. Where the insolvency law allows creditors to
convene a meeting, the law may include certain limitations on when a meeting
can be called or the conditions that must be fulfilled before a meeting can be
called. These conditions may include the expiry of a defined period of time
after a certain step in the proceedings was to be taken; upon the completion of
defined acts or decisions by the insolvency representative; or where the insol-
vency representative fails to act. Some laws also provide that only creditors
holding a specified percentage of the total claims are entitled to call a meeting
(examples include 10 per cent of creditors by value, creditors with no less than
25 per cent of total claims or at least 25 per cent of unsecured claims). A
further approach gives any party in interest the right to apply to the court to
summon a meeting of creditors. Whichever approach is adopted, it is important
that a balance be achieved between facilitating creditor participation and pro-
tection of the interests of creditors on the one hand and efficient and effective
conduct of proceedings without undue delay, on the other.
93. It is desirable that all creditors have the right to be heard on matters to be
discussed at a creditor meeting. Where a vote of creditors is required, it is
196                                      UNCITRAL Legislative Guide on Insolvency Law


desirable that an insolvency law establish the eligibility to vote and the voting
mechanism, including in particular whether creditors are required to attend in
person to vote or whether proxies and other means, such as electronic mail
(e-mail) or the Internet, can be used. Where certain kinds of creditors are
included among a debtor’s creditors, such as public bond holders, special rules
may be required to facilitate their participation in the proceedings, especially
where they exist in large numbers. It may be appropriate, for example, to
permit duly authorized representatives to represent a certain percentage for the
purposes of complying with requirements for the participation of specified
numbers or percentages of creditors at a general meeting of creditors. The
same considerations would also apply to requirements for voting; requirements
for participation and voting in person could significantly complicate insol-
vency proceedings where the debtor’s liabilities include publicly traded bonds.

94. It may also be desirable for an insolvency law to permit creditors to
establish rules governing the actual conduct of their meetings. Issues to be
covered by such rules may include: eligibility to attend and participate; voting
eligibility; the requisite majority for a quorum; chairing; and general conduct
of the meeting. Rules addressing these issues would also be relevant to the
creditor committee and the conduct of its meetings.

                5.   Matters requiring a vote by creditors
95. An insolvency law will need to identify the matters on which a vote of
creditors is required and establish the voting requirements applicable in each
case.

96. Where actions to be taken in the course of the proceedings will have a
significant impact on the creditor body, it is desirable that all creditors be
entitled to receive notice of, and to vote on, those actions. These actions may
include voting to select the insolvency representative, where an insolvency law
provides creditors with this role; approval of a reorganization plan; approval
of post-commencement finance; and on other significant events such as sale of
substantial assets outside the ordinary course of business.

97. A number of different approaches can be taken to achieving that vote,
depending upon the nature of the matter to be decided. Some laws provide that
voting should occur in person at a meeting of creditors, while other laws
provide that where a large number of creditors are involved or where creditors
are not local residents, voting may take place by mail or by proxy. The prac-
ticality of requirements for voting in person will clearly be challenged where
there are large numbers of creditors, and especially of certain kinds of creditor
such as public bond holders, as well as foreign creditors. It will be increasingly
desirable to permit voting to take place using electronic means, including
e-mail and the Internet, subject to appropriate security measures.

98. Different approaches are taken to the type of voting result that is required
to bind creditors to different decisions, with some insolvency laws distinguish-
ing between the different types of decision to be taken. Under some laws, more
Part two: III. Participants                                                   197


important decisions, such as approval of a reorganization plan, may require a
vote that includes both a proportion of value of claims as well as a number of
creditors. Some laws require a majority in value for most decisions, and for
decisions such as election or removal of the insolvency representative and
hiring of particular professionals by the insolvency representative, a majority
in value and number is required. Other laws provide that a simple majority is
sufficient on issues such as election or removal of the insolvency representa-
tive. Some laws also distinguish between matters requiring the support of both
secured and unsecured creditors, for example, secured creditors will only gen-
erally participate in the vote on specified matters such as selection of the
insolvency representative and matters affecting their security interests.


                              6.   Creditor committee
99. As noted above, the formation of a creditor committee or the election or
appointment of a creditor representative is designed to facilitate active creditor
participation in insolvency proceedings, whether liquidation or reorganization.
A creditor committee or other form of creditor representation may not be
required in all insolvency cases, but may be appropriate where, for example,
there is a very large number of creditors, where creditors have very diverse
interests or where other features of the case indicate that such an approach is
desirable or necessary (e.g. to limit time and monetary costs). Some insolvency
laws allow creditors to determine whether or not they will appoint a committee
or representative, while other laws provide for the committee to be appointed
by the court. However appointed, the creditor committee should be able to act
independently of the insolvency representative to ensure fair and unbiased
representation of creditors’ interests. It may be desirable for an insolvency law
to permit creditors to establish rules addressing the matters noted above (see
para. 94) with regard to the conduct of committee meetings.

100. Where a creditor committee is formed, it will be necessary to consider
the extent to which the insolvency estate will pay the costs of the committee;
some insolvency laws allow creditors to form unofficial committees that are
not formally recognized by the court or the insolvency representative and
whose costs are not reimbursed by the insolvency estate but paid by the credi-
tors themselves; other laws provide that the costs of the creditor committee are
to be paid by the estate. The question of who should pay is closely linked to
the role of the committee, the extent to which the functions specified under the
insolvency law to be performed by the creditors can be performed by a com-
mittee or are assisted by the formation of a committee and other factors deter-
mining whether a committee is to be formed in any particular proceeding.
Where the costs are to be borne by the estate, it is desirable for the court to
have the authority to limit excessive expenditure.

(a)   Creditors that may be appointed to a creditor committee
101. An insolvency law that provides for the formation of a creditor commit-
tee will need to consider which creditors will be entitled to be appointed to that
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committee. Different approaches are taken to that issue and, to a great extent,
depend upon the role to be played by creditors in the proceedings. Relevant
factors include the status of a creditor’s claim and the nature of a claim. Some
insolvency laws provide, for example, that only creditors whose claims have
been admitted (by the court or the insolvency representative, depending upon
the admission procedure) can be appointed, while other laws provide for
appointment of a provisional committee, for which all creditors are eligible,
until all claims have been verified and admitted. Other insolvency laws impose
restrictions on the location of creditors who may serve on a creditor committee.
To ensure equality of treatment of creditors, however, it is desirable that credi-
tors such as those whose claims have only been provisionally admitted and
foreign creditors are eligible for appointment to the committee. The choice
between these different approaches is closely related to the functions to be
performed by creditors in the proceedings.

102. A second issue relates to the types of creditor to be represented.
Although creditor committees generally represent only unsecured creditors,
some laws recognize that there may be cases where a separate committee of
secured creditors is justified. Those systems base this approach on the fact that
the interests of the different types of creditor do not always converge and the
ability of secured creditors to participate in, and potentially affect, the outcome
of decisions by the committee may not always be appropriate or in the best
interests of other creditors. Nevertheless, it is also recognized that in certain
circumstances, as already noted, the participation of secured creditors will be
appropriate either because their interests are affected or for other reasons.

103. Other insolvency laws provide for both types of creditor to be repre-
sented on the same committee. One rationale of this approach is that, where the
creditor committee is responsible for participating in decision-making and for
making important decisions, the exclusion of secured creditors may negatively
affect their interests (in particular where they are not fully secured). A further
approach may be for an insolvency law not to specify those creditors which
can be represented in a given case, but to allow creditors to collectively choose
their own representatives on the basis of willingness to serve (to address the
common problem of creditor apathy) and to provide for enlargement or reduc-
tion of the size of the committee as required. Where the types of creditor
requiring representation are too diverse to accommodate their interests within
a single committee, as may be the case for special interest groups such as tort
claimants and equity holders, an insolvency law could provide for different
committees to represent different interests. It is desirable, however, that this
approach be adopted only in special cases, in order to avoid unnecessary costs
and the mechanism for creditor representation becoming unwieldy.

104. The participation of equity holders and creditors related to the debtor
may be controversial, especially where the creditor committee has the power
to affect the rights of secured creditors or where the equity holders are
involved with the management of the debtor. There will be cases, however,
where these parties have no direct knowledge of, or involvement with, the
management of the debtor, such as where they are investors in the debtor. In
Part two: III. Participants                                                   199


such cases, there may be compelling reasons for allowing them to participate
through their own committee. Other creditors who may have a conflict of
interest (such as competitors of the debtor who have a personal interest that has
the potential to affect their impartiality in carrying out the functions of the
committee) may also need to be excluded from participation in a committee in
order to ensure the committee is able to perform its functions on behalf of the
creditor body impartially and independently.

105. A similar question of participation may arise in respect of parties who
purchase the claims of creditors. Such purchasers may be related to the debtor
or may be third parties who have no particular interest in the business of the
debtor. Purchases by third parties may give rise to concerns about access to
sensitive, confidential information that may be of value in the secondary debt
market (see below, para. 115). Purchases by a related party raise the question
of whether the related party should be entitled to claim the original face value
of the claim or only the amount actually paid for it (where there is a difference
between the two), especially where a creditor’s ability to vote is directly
related to the value its claim.

106. To address any potential problem, an insolvency law could adopt the
approach of stipulating those parties which are not entitled to participate in a
creditor committee.

(b)   Formation of a creditor committee
107. Where the law provides for the formation of a creditor committee,
details of the manner in which the committee is to be formed, the scope and
extent of its duties, its governance and operation, including quorum and con-
duct of committee meetings, as well as replacement and substitution of
members are often also addressed. It may be desirable to include provisions in
an insolvency law to address some of these issues, in particular with respect
to duties and replacement and substitution of members, not only to avoid
disputes and ensure confidentiality, but also to provide transparent and predict-
able procedures. Other issues can be addressed in procedural rules adopted by
the committee, including rules on meeting procedure, election of a chairperson
and resolution of disputes.

108. A number of different approaches are taken to appointing the members
of the committee, which depend to a large extent on the functions to be per-
formed by the particular committee. In many cases, creditors are responsible
for appointing the committee, normally at the initial meeting of creditors, or
upon the provision by the insolvency representative of preliminary information
regarding the debtor. Appointment of the committee by creditors may
encourage both creditor confidence and participation in insolvency proceed-
ings. Some jurisdictions allow the court to appoint a creditor committee, either
at its own instigation or upon application by creditors or the insolvency rep-
resentative. This approach may have a number of disadvantages, including that
it has the potential for perceptions of bias and a lack of equity and trans-
parency; creditors may not have confidence in a system that does not
200                                       UNCITRAL Legislative Guide on Insolvency Law


encourage or allow them to play a role in selecting their own representatives;
and it may not serve to overcome the widespread problems of creditor apathy.
On the other hand, such an approach may simplify the procedure for establish-
ing a creditor committee and reduce the scope for disputes between creditors
that can lead to delay and cost. The choice between these different approaches
may depend upon the extent to which the court supervises the insolvency
proceedings and is involved on a day-to-day basis and the extent to which
creditors are required to undertake an active role in performing functions that
require more than the provision of advice to the insolvency representative.
109. To facilitate administration of the committee, some insolvency laws
specify the size of the committee—generally an odd number in order to ensure
the achievement of a majority vote, and in some cases no more than three or
five persons. Where the committee represents only unsecured creditors, mem-
bership of the committee is sometimes limited to the largest unsecured
creditors. These creditors can be identified by a number of means, including
by reference to the list of creditors to be prepared by the debtor. To ensure that
it fulfils its duty to fairly represent all creditors, however, oversight of the
committee may be desirable where the insolvency law requires the committee
to undertake a significant role and could be arranged by the insolvency
representative or by the court.

(c)   Rights and functions of a creditor committee
110. As a general proposition, a creditor committee will perform its func-
tions on behalf of the creditors and those functions will therefore be related
directly to the general functions given to creditors, as noted above. The rights
of a creditor committee and the functions it is required to perform, however,
should not impair the rights of creditors as a whole to continue to participate
or otherwise act in the insolvency proceeding. With respect to decision-
making, the creditor committee will generally play an advisory role, making
recommendations to creditors at large on how key issues should be decided,
but it will not usually have the authority to make major decisions on behalf of
creditors. The creditor committee may also have a role with respect to receiv-
ing notice on behalf of creditors of certain issues of interest to the creditors it
represents. For example, where the insolvency law provides that creditors
should be consulted on the sale of assets outside the ordinary course of busi-
ness, notice of any such proposed sale may be provided through the creditor
committee to save time, minimize costs and facilitate consultation between the
committee and the creditors it represents. While the creditor committee will
interact with the insolvency representative or with the debtor in possession,
where the insolvency law adopts that approach to reorganization, the commit-
tee should be able to act independently of those parties in representing the
interests of creditors.
111. Insolvency laws provide for a creditor committee to undertake a range
of functions, which may include advising the insolvency representative of the
wishes of creditors with respect to issues such as the sale of assets outside the
ordinary course of business and formulation of the reorganization plan;
consulting with the insolvency representative and other principals in the
Part two: III. Participants                                                   201


proceeding, such as the existing management of the debtor; participating in the
development of a reorganization plan; or possibly supervising the insolvency
representative. These functions may be established by the insolvency law,
directed by the court or determined in cooperation with the insolvency
representative.

112. As noted above with respect to creditors generally, the committee will
need to be able to access up-to-date information on the debtor and its financial
affairs and be able to express its views and those of creditors on matters falling
within its functions or on matters that affect the interests of creditors (as to
confidentiality, see below, para. 115). The committee may also require admin-
istrative and expert assistance, although the need for such assistance should be
clearly linked to the functions to be performed by the committee. The commit-
tee may be required under the law to seek permission from the insolvency
representative or the court to hire a secretary and, if circumstances warrant,
consultants and professionals. Some insolvency laws provide that the insol-
vency estate will pay the costs of hiring assistants, including their remunera-
tion, while other laws provide that these costs must be met by creditors as part
of their costs of participation in the insolvency proceedings. Where these costs
are to be paid by the estate, it is desirable that the court have some control not
only over the decision to hire such professionals, but also over the associated
costs and charges.

(d)   Liability of a creditor committee
113. The committee’s duty would be owed to the creditors generally. It
would not have any liability or fiduciary duty to the owners of the insolvent
business. It may be desirable, however, for an insolvency law to require com-
mittee members to act in good faith in carrying out committee functions and
to provide that members of the committee would be immune from liability in
respect of actions and decisions taken by them as members of the committee,
unless they are found to have acted fraudulently or wilfully or to have
breached a fiduciary duty to the creditors they represent. This might include,
for example, deriving profit from the administration of the estate; acquiring
assets forming part of the estate without prior approval of the court; or taking
advantage of confidential information received as a committee member. The
standard of liability applicable to members of the committee can be distin-
guished from that of the insolvency representative; committee members are not
required to satisfy any requirements as to knowledge or expertise and are
acting in a voluntary capacity without remuneration. In considering the ques-
tion of the liability of the committee, a balance may need to be struck between
setting too high a level of responsibility that will effectively discourage credi-
tors from participating and too low a level that may lead to abuse and prevent
the committee from functioning efficiently as a representative body.

(e)   Removal and replacement of members of a creditor committee
114. An insolvency law may need to give some consideration to the grounds
upon which removal of a member of the creditor committee might be justified
202                                           UNCITRAL Legislative Guide on Insolvency Law


and to establishing a mechanism for replacement. Those grounds might include
gross negligence; lack of the necessary skills; incompetence; inefficiency; lack
of independence; breach of confidence; or conflict of interest. The procedure
for such removal and replacement will generally depend upon the procedure
for appointment of a creditor committee, whether by the court or election by
creditors. A mechanism for replacement of members of the committee will also
be relevant where members of the committee resign or are unable to continue
performing the required functions, such as in cases of serious illness or death.

                                 7.    Confidentiality
115. As already noted (see above, paras. 28 and 52), it is desirable that an
insolvency law impose obligations of confidentiality on both the debtor and the
insolvency representative. For similar reasons, it may also be appropriate to
consider the circumstances in which creditors should be required to observe
confidentiality. In the course of the administration of insolvency proceedings,
creditors will generally be in a position to obtain significant amounts of infor-
mation concerning the debtor and its business, much of which may be commer-
cially sensitive. While the consequences of liquidation suggest that there may
not be much opportunity for creditors to take unfair advantage of that informa-
tion (or that harm to the debtor will result), that may not be true of reorgani-
zation, and there may be circumstances where creditors can use that infor-
mation to affect the successful implementation of an agreed plan. For these
reasons, it may be appropriate to impose on creditors and the creditor com-
mittee (and any professionals employed by it) an obligation of confidentiality
that permits the use of information obtained in the course of the proceedings
only for the purposes of administration of the proceedings, unless the court
decides otherwise. In cases where a creditor committee is appointed (and the
committee hires professional advisors), the obligation may be given effect by
requiring members of the committee (and the professional advisors) to sign
confidentiality agreements.



                             Recommendations 126-136

      Purpose of legislative provisions
          The purpose of provisions on participation of creditors in insolvency pro-
      ceedings is:
           (a) To facilitate participation of creditors in insolvency proceedings;
           (b) To provide a mechanism for the appointment of a creditor committee
      or other creditor representative where to do so would facilitate the participa-
      tion of creditors in the insolvency proceedings;
           (c) To ensure the right of creditors to access information on the insol-
      vency proceedings; and
           (d) To specify the functions and responsibilities of the creditor commit-
      tee or other representative.
Part two: III. Participants                                                                      203




     Contents of legislative provisions

     Right to be heard
          See recommendations 133 and 137.

     Confidentiality
          See recommendation 111.

     Participation by creditors (paras. 75-87)
          126. The insolvency law should specify that creditors, both secured and
     unsecured, are entitled to participate in insolvency proceedings and identify
     what that participation may involve in terms of the functions that may be
     performed.

     Voting by creditors (paras. 96-98)
          127. The insolvency law should specify the matters on which a vote of
     creditors is required and establish the relevant eligibility and voting require-
     ments. In particular, the insolvency law should require creditors to vote on
     approval or rejection of a reorganization plan.

     Convening meetings of creditors (paras. 91-94)
          128. The insolvency law may require a first meeting of creditors to be
     convened within a specified period of time after commencement to discuss
     matters specified in the insolvency law. The insolvency law may also permit
     the court, the insolvency representative or creditors holding a specific percent-
     age of the total value of unsecured claims to request the convening of any
     other meeting of creditors and specify the circumstances in which such a
     meeting may be convened. The insolvency law should specify the party re-
     sponsible for giving notice of such a meeting to creditors.

     Creditor representation (paras. 88-90)
          129. The insolvency law should facilitate the active participation of
     creditors in insolvency proceedings such as through a creditor committee, a
     special representative or other mechanism for representation.11 The insolvency
     law should specify whether a committee or other representation is required in
     all insolvency proceedings. Where the interests and categories of creditors
     involved in insolvency proceedings are diverse and participation will not be
     facilitated by the appointment of a single committee or representative, the
     insolvency law may provide for the appointment of different creditor commit-
     tees or representatives.


       11
         See above, paras. 2-21 and recommendations 112 and 113, on the continuing role of the debtor
in reorganization. Where the debtor remains in possession of the business, a creditor committee or
other creditor representative will have an important role to play in overseeing and, where necessary,
reporting on the activities of the debtor.
204                                              UNCITRAL Legislative Guide on Insolvency Law




      Recommendations 126-136 (continued)
           130. Where the insolvency law permits a creditor committee or repre-
      sentative to be appointed, the relationship between the creditors and the
      creditor committee or representative should be clearly specified.12 The insol-
      vency law should specify how the costs of the creditor committee would be
      paid.

      Creditors that may be appointed to a creditor committee (paras. 101-106)
           131. The insolvency law should specify the creditors that are eligible to
      be appointed to a committee. Creditors who may not be appointed to a creditor
      committee would include related persons and others who for any reason might
      not be impartial. The insolvency law should specify whether or not a creditor’s
      claim must be admitted before the creditor is entitled to be appointed to a
      committee.

      Mechanism for appointment to a creditor committee (paras. 107-109)
           132. The insolvency law should establish a mechanism for appointment
      of a creditor committee. Different approaches may include selection of the
      creditor committee by creditors or appointment by the court or other admi-
      nistrative body.

      Rights and functions of a creditor committee (paras. 110-112)
           133. The insolvency law should specify the rights and functions of the
      creditor committee in insolvency proceedings, which may include:
           (a) Providing advice and assistance to the insolvency representative or
      the debtor-in-possession;
          (b) Participating in development of the reorganization plan;
           (c) Receiving notice of and being consulted on matters in which their
      class has an interest, including the sale of assets outside the ordinary course
      of business;
          (d) The right to hear the insolvency representative at any time; and
          (e) The right to be heard in the proceedings.

      Employment and remuneration of professionals by a creditor committee
      (para. 112)
           134. The insolvency law should permit a creditor committee, subject to
      approval by the court, to select, employ and remunerate professionals that may
      be needed to assist the creditor committee to perform its functions. The
      insolvency law should specify how the costs and remuneration of those
      professionals would be paid.



      12
         In particular, the insolvency law should specify the distribution of functions and powers
between the creditors and the creditor committee and the mechanism for resolution of disputes be-
tween the creditors and the creditor committee.
Part two: III. Participants                                                                  205




     Liability of a creditor committee (para. 113)
          135. The insolvency law should specify that members of a creditor com-
     mittee are exempt from liability for their actions in their capacity as members
     of the committee unless they are found to have acted fraudulently or to be
     guilty of wilful misconduct.

     Removal and replacement of members of a creditor committee (para. 114)
        136. The insolvency law should specify the grounds for removal of
     members of a creditor committee and provide for their replacement.13




           D.   Party in interest’s right to be heard and to appeal
                                 1.   Right to be heard
116. Many insolvency laws provide creditors, as the primary beneficiaries of
the estate, and other parties in interest with some ability to scrutinize both the
administration of the estate and the conduct of the insolvency representative in
performing its duties. The insolvency representative, the debtor, a creditor, a
creditor committee or another party in interest may wish to request relief under
the insolvency law or may oppose requests of others for such relief. Each of
those parties should have a right to be heard when their rights, interests in
assets or duties under the insolvency law are affected. Where decisions relating
to administration of the estate are to be made by the courts, those decisions
may generally be appealed to a higher court by a party whose interests are
affected, although some insolvency laws do exempt certain decisions from
appeal (e.g. the decision appointing the supervising judge or commencing the
proceedings).

                                2.    Review procedures
117. Procedural approaches to the administration of an estate are determined
to a large extent by the rules governing the duties of the insolvency representa-
tive, the rights and duties of the debtor under the insolvency law and the active
role, if any, of creditors, either separately or through a creditor committee or
other representative, in the administration. For example, in those laws which
require the insolvency representative to gain the approval of creditors, or their
representatives, before undertaking certain acts, direct involvement of creditors
in decision-making will normally preclude the need to permit creditors to seek
court review of those acts, apart from in situations where the insolvency
representative has misled creditors.


      13
       Exercise of the power to remove will depend on the method of appointment of the committee.
206                                           UNCITRAL Legislative Guide on Insolvency Law


118. Where acts of the insolvency representative are not subject to the prior
approval of creditors, it may be appropriate to permit creditors to request the
court to review the insolvency representative’s decision. Such a review pro-
cedure may be appropriate for other parties in interest when acts of the
insolvency representative affect them.

119. Most insolvency laws require a party in interest to raise its requests for
relief or objections through the court. Some insolvency laws allow individual
creditors to bring an action, while others require the objecting creditor or
creditors to represent a certain number of creditors or percentage of the debt
to have legal standing to proceed with an action, or even require an action to
be brought by the creditor committee or the creditors generally. Such require-
ments may depend upon the grounds of the objection raised. Other parties in
interest may have legal standing to raise an objection or request relief when
their rights, interests in assets or duties under the insolvency law are affected.
As discussed above, the right to be heard must be balanced with the need for
efficient administration of the insolvency proceedings.


                                 3.   Right of appeal
120. A party in interest who has requested relief and been denied or who has
unsuccessfully opposed a request or act of another party should have a right
to appeal to a higher court if it believes that the court was in error. Most
judicial systems establish a hierarchy of courts for appellate review and pro-
cedures to invoke that review. A similar structure should apply to the court that
administers the insolvency law and to orders entered by that court.



                           Recommendations 137 and 138

      Purpose of legislative provisions
          The purpose of legislative provisions on review and appeal is:
           (a) To ensure that parties in interest have a right to be heard and seek
      relief from the court when their rights, interests in assets or duties under the
      insolvency law are affected; and
          (b) To establish procedures for providing relief and for appellate review.

      Contents of legislative provisions
      Right to be heard and to request review (paras. 116-119)
           137. The insolvency law should specify that a party in interest has a right
      to be heard on any issue in the insolvency proceedings that affects its rights,
      obligations or interests. For example, a party in interest should be entitled:
          (a) To object to any act that requires court approval;
Part two: III. Participants                                                                     207




         (b) To request review by the court of any act for which court approval
     was not required or not requested; and
          (c) To request any relief available to it in insolvency proceedings.

     Right of appeal14 (para. 120)
           138. The insolvency law should specify that a party in interest may
     appeal from any order of the court in the insolvency proceedings that affects
     its rights, obligations or interests.




                                 E.     Secured creditors
121. As already noted, under some insolvency laws the rights of secured
creditors are unaffected by the commencement of proceedings and they may
proceed to enforce those rights unimpeded by the insolvency proceedings.
Under many insolvency laws, however, the rights of secured creditors are
affected, for example, by the application of a stay against the right to enforce
their security interest, by the reorganization and so on.

122. The rights of secured creditors are discussed throughout the Legislative
Guide in the context of the provisions of an insolvency law that may affect
those rights. With respect to some issues, the Guide makes specific reference
to secured creditors and the manner in which they may be affected by the
commencement of insolvency proceedings, for example, with respect to
constitution of the insolvency estate, application of the stay and post-
commencement finance. With respect to other issues, the commentary draws
no distinction between types of creditor in terms of the application of the
insolvency law and secured creditors will be affected in the same manner as
other creditors.

123. A list of references to the sections of the Guide (to both paragraphs of
the commentary and recommendations) addressing the treatment of secured
creditors and their rights in insolvency is included in annex I. For a complete
picture of how secured creditors are affected by commencement of insolvency
proceedings, however, the Guide should be read as a whole.


      14
        In accordance with the key objectives, the insolvency law should provide that appeals in
insolvency proceedings should not have suspensive effect unless otherwise determined by the court,
in order to ensure that insolvency can be addressed and resolved in an orderly, quick and efficient
manner without undue disruption. Time limits for appeal should be in accordance with generally
applicable law, but in insolvency need to be shorter than otherwise to avoid interrupting insolvency
proceedings.
                            IV. Reorganization
                       A.    The reorganization plan
                               1.   Introduction
1. In the preceding chapters, the Legislative Guide discusses a number of
matters relevant to reorganization proceedings. A central element of those
proceedings is the reorganization plan and insolvency laws generally address
a number of issues in relation to the plan. These include the nature or form of
the plan; when it is to be prepared; who is permitted to prepare a plan; its
content; how it is to be approved by creditors; whether court confirmation is
required; the effect of the plan and how it is to be implemented.

2. Reorganization plans perform different functions in different types of pro-
ceeding. In some, the plan may be the tailpiece of the reorganization proceed-
ings, dealing with the payout of a dividend in full and final settlement of all
claims and the final structure of the business after the reorganization is com-
plete. In others, the plan may be proposed at the commencement of the
proceedings and set out the way the debtor and the business should be dealt
with during the reorganization period, much like a business plan, as well as
expected dividends and dates of payment. There may also be circumstances
where a plan, like a plan of reorganization, is prepared in liquidation where the
business is to be sold as a going concern. Such a plan may address issues such
as the timing and mechanics for interim distributions. The following discussion
focuses upon the issues that would be relevant to a plan proposed at some time
after the proceedings have commenced, addressing the conduct of the business
in reorganization and the transformation of legal rights proposed to address the
debtor’s financial situation. These considerations will also be relevant,
although not necessarily in their entirety, to other types of plan.


                       2.    Nature or form of a plan
3. The purpose of reorganization is to maximize the possible eventual return
to creditors, providing a better result than if the debtor were to be liquidated
and to preserve viable businesses as a means of preserving jobs for employees
and trade for suppliers. With different constituents involved in reorganization
proceedings, each may have different views of how the various objectives can
best be achieved. Some creditors, such as major customers or suppliers, may
prefer continued business with the debtor to rapid repayment of their debt.
Some creditors may favour taking an equity stake in the business, while others
will not. Typically, therefore, there is a range of options from which to select
in a given case. If an insolvency law adopts a prescriptive approach to the

                                       209
210                                        UNCITRAL Legislative Guide on Insolvency Law


range of options available or to the choice to be made in a particular case, it
is likely to be too constrictive. It is desirable that the law not restrict reorgani-
zation plans to those designed only to fully rehabilitate the debtor; prohibit
debt from being written off; restrict the amount that must eventually be paid
to creditors by specifying a minimum percentage; or prohibit exchange of debt
for equity. A non-intrusive approach that does not prescribe such limitations is
likely to provide sufficient flexibility to allow the most suitable of a range of
possibilities to be chosen for a particular debtor.

4. Some insolvency laws adopt an illustrative approach, listing some of the
possibilities that may be adopted, but it is not intended that the list be exhaus-
tive or exclusive of other approaches. These possibilities could include a
choice of a simple composition (an agreement to pay creditors a percentage of
their claims, usually over time); the continued trading of the business and its
eventual sale as a going concern (and for the debtor to then be liquidated);
transfer of all or part of the assets of the estate to one or more existing
businesses or to businesses that will be established; a merger or consolidation
of the debtor with one or more other business entities; a sophisticated form of
restructuring of debt and equity; or some other solution. The determination of
what is the most appropriate solution may best be left to the market place,
where an effective one exists, or at least to negotiations between the debtor, the
insolvency representative, creditors and other parties in interest.

5. Even if it does not adopt a prescriptive approach to the form or nature of
the plan, an insolvency law may establish some guiding principles, such as that
the priorities afforded to creditors in liquidation should be maintained in
reorganization, that creditors receive in reorganization as much as they would
have received in liquidation, that the effect of the plan should not be such that
the debtor remains insolvent and is returned to the marketplace in that condi-
tion and that the reorganization plan complies with limitations set forth in other
laws (unless it is intended that the insolvency law amend those limitations),
such as foreign exchange controls.


                   3.   Proposal of a reorganization plan
6. Two important issues to be considered in relation to the proposal of a
reorganization plan are the stage of the proceedings at which it should be
proposed and the party or parties that would be capable of proposing, or could
be authorized to propose, a plan. A number of different approaches can be
taken to each of these issues.

(a)   Timing of proposal
7. As to the first issue, timing of proposal, the approach adopted may depend
upon the purpose or objective of the particular reorganization, or relate to the
manner in which the reorganization proceedings commenced. Some laws, for
example, provide that a reorganization plan should be filed with the application
for reorganization proceedings (where the application may be called a
Part two:    IV. Reorganization                                                              211


“proposal” for reorganization) where the debtor made the application for com-
mencement of those proceedings.1 This approach may delay the debtor’s ability
to seek commencement of proceedings and obtain timely relief by way of the
stay. It may also be difficult to know, at the time the application is made,
exactly what the plan should accomplish. If the plan has been prepared without
consultation with creditors and other interested parties but is intended to be a
final, definitive plan, it may not be a plan that would receive the approval of
creditors and be successfully implemented. Many other laws provide for the
plan to be negotiated and proposed after commencement of reorganization
proceedings. This may be a more flexible option, allowing consultation and
negotiation of an acceptable reorganization plan while the debtor has the pro-
tection of the stay. These benefits may need to be balanced against possible
misuse of the insolvency regime by debtors who have no intention of pro-
posing, or the ability to propose, a plan but are seeking to obtain only the
benefits of the stay. Issues of timing of proposal of the plan may also arise
where proceedings are converted from liquidation to reorganization (see
below, paras. 72-75).

(b)      Parties permitted to propose a plan
8. With regard to the second issue, participants in the reorganization proceed-
ings may have different capabilities and responsibilities with regard to nego-
tiation and proposal of a reorganization plan, depending upon the manner in
which the insolvency law is designed and the respective roles assigned to the
insolvency representative, debtor and creditors. For example, in some insol-
vency laws, these parties have a positive obligation to cooperate in negotiating
and proposing a plan. In determining which party should be permitted to
propose, or which parties are capable of proposing, a plan, a balance may be
desirable between the freedom accorded to the different parties to propose a
plan (e.g. should all parties be able to propose a plan, should they be able to
do so at the same time or should proposal by different parties be sequential and
dependant upon the acceptability of a plan proposed) and the restraints neces-
sarily attached to the process in terms of approval (voting) requirements
(e.g. should all creditors play a role in formulating a plan they have to
approve), time limits for negotiation and proposal, possible amendment of the
plan and other procedural considerations. A flexible approach, as opposed to
a prescriptive approach, is likely to ensure that this balance is achieved,
although in the interests of efficiency, certainty and predictability and the
timely progress of the proceedings, it is desirable that an insolvency law
provide sufficient guidance to ensure that a viable plan is proposed.

   (i)      Proposal by the debtor
9. Where the plan is to be proposed before commencement, it would gener-
ally be proposed by the debtor, but may involve negotiation with one or more
classes of creditors, who may negotiate and agree on a plan, subject to its

     1
       This type of approach is not to be confused with an application for expedited proceedings,
which would be accompanied by the plan approved by creditors, see recommendation 162.
212                                      UNCITRAL Legislative Guide on Insolvency Law


acceptance by other creditors or its imposition on remaining classes. Where the
plan is to be proposed after the commencement of proceedings, some insol-
vency laws provide that the debtor should propose a plan, sometimes specify-
ing that it should do so in cooperation with other parties such as the insolvency
representative, the creditors, an attorney, an accountant or other financial
advisors. An approach involving the debtor may have the advantage of encour-
aging debtors to commence reorganization proceedings at an early stage and,
where the plan envisages the ongoing operation of the debtor’s business, of
making the best use of the debtor’s familiarity with its business and knowledge
of the steps necessary to make the insolvent business viable. The freedom
accorded to the debtor in this regard may need to be balanced against the need
to ensure creditor confidence in the debtor and its proposal. The benefits of
such an approach also may be clear where key management personnel of the
debtor are necessary to the success of the business (e.g. because of its
complexity) or will be difficult to replace in the short term.

10. Some insolvency laws give the debtor an exclusive opportunity to propose
a plan. Other laws adopt a staged approach, limiting the debtor’s exclusive
opportunity to a specified period of time. The court may have the power to
extend the period if the debtor can show that the extension is justified and there
is a real prospect of a successful reorganization plan being proposed. Where
the debtor’s exclusive period expires without a plan being proposed, another
party is able to propose a plan.

  (ii) Proposal by creditors
11. Where creditor approval of the plan is required, there is always a risk that
reorganization will fail if the plan presented by the debtor is not acceptable.
For example, creditors may only wish to approve a plan that deprives the
debtor’s equity holders of a controlling equity interest in the business and the
incumbent management of any management responsibilities. If the debtor has
an exclusive opportunity to propose the plan and refuses to consider such
arrangements, there is a danger that the reorganization will fail, to the detri-
ment of the creditors, the employees and the debtor itself. To address such a
situation, some insolvency laws provide that, in preparing its plan, the debtor
should cooperate and negotiate with creditors and if it fails to propose an
acceptable plan before the end of an exclusive period, the creditors are given
the opportunity to propose a plan (which could be achieved through a creditor
committee). This option may provide the leverage necessary to reach a
compromise between the participating parties.

  (iii) Proposal by the insolvency representative
12. Another approach adopted by many insolvency laws is to give the insol-
vency representative an opportunity to propose a plan, either as an alternative
to proposal by the debtor or the creditors or as a supplementary measure.
Given that the insolvency representative will have had some opportunity to
become knowledgeable about the debtor’s business after commencement of the
proceedings, it may be well placed to determine what measures are necessary
Part two:   IV. Reorganization                                                213


for the business to be viable. It may also be well placed to facilitate negotia-
tions on the plan between the debtor and creditors. The importance of pro-
viding for participation by the insolvency representative depends upon the
design of the law and, in particular, requirements for approval of the plan by
creditors or the court. Where approval by creditors is required, a plan that takes
account of proposals that will be acceptable to creditors has a greater likeli-
hood of being approved than one that does not. This consideration may not
apply where creditor approval is not necessary. Where the plan is to be
approved only by the court, substantial legal input may be required to ensure
that the plan presented will be approved. Where the insolvency representative
is not given the opportunity to negotiate and propose a plan or to participate
in that process, it may be desirable to give the insolvency representative an
opportunity to consider a proposed plan before it is submitted to creditors and
others for approval.

      (iv) Proposal by multiple parties
13. Some insolvency laws provide that a number of parties have the oppor-
tunity to propose a plan. These may include the debtor, the insolvency repre-
sentative and creditors or the creditors committee. It may be desirable where
such a provision is included that some procedure be adopted to ensure that a
number of competing plans are not proposed simultaneously. Although in
some cases this competitive approach may promote the proposal of a mutually
acceptable plan, it may also have the potential to complicate the proceedings
and lead to confusion, inefficiency and delay.

14. Some laws provide for the court to consider the opinions of third parties
on the plan, such as governmental agencies and labour unions. Although in-
cluding these parties in plan negotiation in particular cases may assist in the
proposal of an acceptable plan, it also has the potential, if adopted as a general
principle, to complicate and lengthen the duration of the proceedings. It may
be desirable only if it is likely to be beneficial in a particular case where the
interests of those parties are central to the reorganization plan and where the
negotiation process is carefully monitored and time limits are specified.

(c)     Time limits for proposal of a plan
15. Some insolvency laws specify a time period after commencement within
which a plan is to be proposed. This limit may apply specifically to proposal
of a plan by the debtor or generally. One law, for example, provides a 120-day
limit for proposal of a plan by the debtor; once that has expired any other party
may propose a plan without any time limit being imposed. Examples of time
limits generally applicable to negotiation and proposal of a plan range from 35
to 120 days from commencement, with some laws including provision for that
time limit to be extended or shortened by the court in certain circumstances.
Although the imposition of time limits may be helpful in ensuring that the
reorganization proceeds without delay, that advantage may need to be balanced
against the risk that the deadline may be too inflexible and impose an arbitrary
restraint, in particular in large cases where negotiation and proposal of a plan
214                                      UNCITRAL Legislative Guide on Insolvency Law


may take significantly longer, such as more than 12 months; that the limits will
not be observed, especially in the absence of appropriate sanctions; or that the
insolvency infrastructure is unable to manage deadlines (for reasons such as
lack of resources). One means of addressing the concern of inflexibility is to
provide for the time period to be extended by the court, provided the extension
is for a further limited period and that an unlimited number of extensions is not
available. An advantage of that approach is that the party seeking an extension
will be required to demonstrate to the court that the extension is warranted—
that is, for example, that there are proper reasons for the delay (e.g. it is
because of a need for further consultations with creditors or there has been a
delay in receiving assessments or reports from professional advisors); that the
delay will not be harmful to the interests of the other parties; and that, if the
extension is granted, there is a real prospect for proposal of a plan that will be
approved by creditors.

16. Where an insolvency law includes time periods for the negotiation and
proposal of a plan, consideration will need to be given to those proceedings
which are converted to reorganization from liquidation. The standard time
periods that would be applicable by reference to the effective date of com-
mencement of proceedings (i.e. the liquidation proceedings) may not easily be
applied in cases that rely on the original application for commencement and
treat the conversion as a continuation of those proceedings, as a significant
period of time may have elapsed between commencement of the proceedings
and their conversion.


                                 4.   The plan
17. The outcome of the plan rests on what is feasible, that is, whether, on the
basis of known facts and circumstances and reasonable assumptions, the plan
and the debtor are more likely than not to succeed. Determination of whether
a plan is likely to succeed raises two related issues. The first is the content of
the plan itself and what it proposes. The second is the manner in which those
proposals are presented and explained to creditors in order to elicit their
support.

(a)   Content of a plan
18. The question of what is to be included in the plan is closely related to the
procedure for approval of the plan, that is, which creditors are required to
approve the plan and the level of support required for approval, the effect of
the plan once approved, that is, will it bind dissenting creditors and secured
creditors and who will be responsible for implementation of the plan and for
ongoing management of the debtor, and whether or not there is a requirement
for court confirmation. Many insolvency laws include provisions addressing
the content of the reorganization plan. Some laws address the content of the
plan by reference to general criteria, such as requirements that the reorganiza-
tion plan should adequately and clearly disclose to all parties information
regarding both the financial condition of the debtor and the transformation of
Part two:   IV. Reorganization                                                 215


legal rights that is being proposed in the plan, or by reference to minimal
requirements, such as that the plan must make provision for payment of certain
preferred claims. It should be noted that a plan need not modify or otherwise
affect the rights of every class of creditor.

19. Other laws set out more specific requirements as to what information is
required in relation to the debtor’s financial situation and the proposals that can
be included in a plan. Information on the financial situation of the debtor could
include asset and liability statements; cash flow statements; and information
relating to the causes or reasons for the financial situation of the debtor. Infor-
mation relating to what is proposed by the plan could include, depending upon
the objective of the plan and the circumstances of a particular debtor, details
of classes of claims; claims modified or affected under the plan and the treat-
ment to be accorded to each class under the plan; the continuation or rejection
of contracts that are not fully executed; the treatment of unexpired leases;
measures and arrangements for dealing with the debtor’s assets (e.g. transfer,
liquidation or retention); the sale or other treatment of encumbered assets; the
disclosure and acceptance procedure; the rights of disputed claims to take part
in the voting and provisions for disputed claims to be resolved; arrangements
concerning personnel of the debtor; remuneration of management of the
debtor; financing implementation of the plan; extension of the maturity date or
a change in the interest rate or other term of outstanding security interests; the
role to be played by the debtor in implementation of the plan and identification
of those to be responsible for future management of the debtor’s business; the
settlement of claims and how the amount that creditors will receive will be
more than they would have received in liquidation; payment of interest on
claims; distribution of all or any part of the assets of the estate among those
having an interest in those assets; possible changes to the instrument or organic
document constituting the debtor (e.g. changes to by-laws or articles of asso-
ciation) or the capital structure of the debtor or merger or consolidation of the
debtor with one or more persons; the basis upon which the business will be
able to keep trading and can be successfully reorganized; supervision of the
implementation of the plan; and the period of implementation of the plan,
including in some cases a statutory maximum period.

20. Rather than specifying a wide range of detailed information to be included
in a plan, it may be desirable for the insolvency law to identify the minimum
content of a plan, focusing upon the key objectives of the plan and procedures
for implementation. For example, the insolvency law may require the plan to
detail the classes of creditors and the treatment each is to be accorded in the
plan; the terms and conditions of the plan (such as treatment of contracts and
the ongoing role of the debtor); and what is required for implementation of
the plan (such as sale of assets or parts of the business, extension of maturity
dates, changes to capital structure of the business and supervision of
implementation).

21. The content of the plan also raises issues related to other laws. For
example, to the extent that national law precludes debt-for-equity conversions,
a plan that provides for such a conversion could not be approved. Since
216                                      UNCITRAL Legislative Guide on Insolvency Law


debt-for-equity conversion can be an important feature of reorganization, it
would be necessary to eliminate the prohibition, at least in the insolvency
context, if such provisions were to be included in a plan and approved. Simi-
larly, if a plan is limited by the operation of law other than the insolvency law
to providing only for debt forgiveness or the extension of maturity dates, it
may be difficult to obtain creditor approval. Some insolvency cases raise simi-
larly straightforward and uncontroversial issues of the relationship between the
insolvency law and other laws. Other cases may raise more complicated
questions. These may include limits on foreign investment and foreign
exchange controls (especially in cases where many of the creditors are non-
residents) or the treatment of employees under relevant employment laws
where, for example, the reorganization may raise questions of modification of
collective bargaining agreements, or questions related to taxation law.

22. Approaches to these issues vary. In some States, the insolvency law will
be subject to the limitations contained in other laws, with the consequence that
options for reorganization may be restricted. Other insolvency laws allow some
of those limitations, for example those relating to disposition of the debtor’s
assets and priority of distribution, to be overruled in specified circumstances,
such as where creditors agree. It is desirable that limitations in other laws that
will affect the insolvency law be considered in designing the insolvency law
and that, in order to ensure transparency and predictability, an insolvency law
specifically address its relationship with other laws. Where possible, an insol-
vency law should note the impact of those other laws.


(b)   Information to accompany the plan
23. Creditors and other relevant parties in interest (such as equity holders),
who may be required to vote on the plan, need to be able to assure themselves
that what is proposed by the plan is feasible and not based, for example, on
faulty assumptions and that implementation of the plan will not leave the
debtor overburdened with debt. To facilitate that evaluation, creditors and
other parties in interest need to be provided with information explaining what
the plan proposes and the impact of those proposals on their rights and claims.
For these purposes, the plan can be submitted to creditors and others together
with a disclosure statement that provides a full disclosure of information that
will enable all parties to properly evaluate the plan. That statement may be
prepared by a qualified professional who can be expected to provide a credible
and unbiased assessment of the measures proposed by the plan or by the party
who proposes the plan, with or without professional advice. Where the
insolvency representative is not involved in the proposal of a plan or pre-
paration of the disclosure statement, it may be desirable to require it to
comment on both instruments. Where creditors and other parties in interest
do not agree with the professional evaluation or do not believe that the
disclosed information is persuasive, their views could be taken into account in
the course of approval by allowing the plan as proposed to be amended or in
the course of the confirmation process (if confirmation is required by the
insolvency law).
Part two:   IV. Reorganization                                                217


24. A number of insolvency laws include provisions specifying the informa-
tion that is to be provided to creditors and other interested parties to enable
them to properly assess the plan, whether it is to be included in the plan itself
or in a separate statement. A requirement to provide this information, sup-
ported by appropriate mechanisms for obtaining it, satisfies the key objective
of transparency and can assist in ensuring creditor confidence in insolvency
proceedings. It may need to be balanced, however, against confidentiality
concerns arising from access to potentially sensitive financial and commercial
information relating to the debtor, even where that information may ultimately
enter the public domain through approval or confirmation of the plan by a
court. This concern can be addressed in the law by including obligations to
observe confidentiality that will apply to the debtor, creditors, the insolvency
representative and other parties in interest. The requirement to provide
information should not be misused by supplying information that is irrelevant
to evaluation of the plan; the focus should be upon the information required
in a particular case to evaluate the specific proposals contained in the plan.

25. It is desirable that an insolvency law specify the minimum information to
be provided in a disclosure statement. This could include information relating
to the financial situation of the debtor, including asset and liability and cash
flow statements; non-financial information that might have an impact on the
future performance of the debtor (e.g. the availability of a new patent); a
summary of the plan; a comparison of the treatment afforded to creditors by
the proposed plan and what they could be expected to receive in liquidation;
the basis upon which the debtor’s business would be able to keep trading and
be successfully reorganized; information on voting mechanisms applicable to
approval of the plan; and information showing that, having regard to the effect
of the plan, adequate provision has been made for satisfaction of all obligations
provided for in the plan and that the debtor is expected to have the cash flow
to pay its debts as provided for in the plan.



                                 5.   Approval of a plan
(a)   Issues to be considered
26. Designing the provisions of an insolvency law on approval of the plan
requires a number of different issues to be considered, such as whether all
creditors and equity holders are entitled to vote on the plan; whether voting on
approval of the plan should be conducted in classes; and the manner in which
creditors that do not approve a plan (“dissenting creditors”) will be treated.
Some underlying principles are that creditors whose rights are modified or
affected by a plan, including secured creditors, can only be bound by the plan
if they have been given the opportunity to vote on that plan; that secured
creditors should vote separately from unsecured creditors; that creditors of the
same class should each receive the same treatment under the plan; and that a
dissenting class of creditors that is to be bound to the plan should receive as
least as much as they would have received in liquidation proceedings.
218                                       UNCITRAL Legislative Guide on Insolvency Law


  (i)    Classification of claims
27. The primary purpose of classifying claims is to satisfy the requirements
to provide fair and equitable treatment to creditors, treating similarly situated
claims in the same manner and ensuring that all creditors in a particular class
are offered the same menu of terms by the reorganization plan. It is one way
to ensure that priority claims are treated in accordance with the priority estab-
lished under the insolvency law. It may also make it easier to treat the claims
of major creditors who can be persuaded to receive different treatment from the
general class of unsecured creditors, where that treatment may be necessary to
make the plan feasible. Classification can, however, increase the complexity
and costs of the insolvency proceedings, depending upon how many different
classes are identified. An alternative, to ensure that creditors who should
receive special treatment are not oppressed by the majority, may be to give
those groups the opportunity to challenge the decision of the majority in court
if they have not been treated in a fair and equitable manner. The fact that such
a facility exists may operate to discourage majorities from making proposals
that would unfairly disadvantage priority creditors.

  (ii) Treatment of dissenting creditors
28. As to the treatment of dissenting creditors, it will be essential to provide
a way of imposing a plan agreed by the majority of a class upon the dissenting
minority in order to increase the chances of success of the reorganization. It
may also be necessary, depending upon the mechanism that is chosen for
voting on the plan and whether creditors vote in classes, to consider whether
the plan can be made binding upon dissenting classes of creditors and other
affected parties.
29. To the extent that a plan can be approved and enforced upon dissenting
parties, there will be a need to ensure that the content of the plan provides
appropriate protection for those dissenting parties and, in particular, that their
rights are not unfairly affected. The law might provide, for example, that
dissenting creditors can not be bound unless assured of certain treatment. As
a general principle, that treatment might be that the creditors will receive at
least as much under the plan as they would have received in liquidation pro-
ceedings. If the creditors are secured, the treatment required may be that the
creditor receives payment of the value of its security interest, while in the case
of unsecured creditors it may be that any junior interests, including equity
holders, receive nothing. To the extent that the approval procedure results in
a significant impairment of the claims of creditors and other affected parties
without their consent (in particular secured creditors), there is a risk that credi-
tors will be unwilling to provide credit in the future. The mechanism for
approval of the plan, and the availability of appropriate safeguards, is therefore
of considerable importance to the protection of these interests.

(b)     Procedures for approval
30. Many insolvency laws provide for a special meeting of creditors to be
called for the purpose of voting on the reorganization plan and require that the
Part two:    IV. Reorganization                                               219


plan (and the information or disclosure statement, where applicable) be made
available to those creditors and other parties in interest (including equity
holders) who are entitled to vote at the meeting within a certain period of time
before that meeting is called. Some laws require voting to occur in person at
a meeting of creditors, while other laws also allow voting by mail or by proxy.
To facilitate voting and recognize the increasing use of electronic means of
communication, it may be desirable to permit voting to take place in person,
by proxy and by electronic means.
31. Other issues to be considered with regard to approval of the plan include
whether creditors and other parties in interest should vote in classes according
to their respective rights; the types of claim (in terms of admission or pro-
visional admission of those claims) that will be considered in determining
whether the requisite voting majority has been reached; whether secured credi-
tors are entitled to vote; whether the votes of priority claims will be considered
in determining the requisite majority; which parties in interest, in addition
creditors, are entitled to vote on the plan; and the manner in which abstaining
or non-participating creditors will be treated. These issues are discussed in the
paragraphs below.

   (i)      Treatment of abstaining or non-participating creditors
32. With respect to the last issue, some laws treat abstaining or non-
participating voters as votes not to accept a plan. Such an approach may have
the effect of disenfranchising those creditors who did participate and vote on
approval of the plan and may in practice make it very difficult to obtain the
requisite majority to approve a plan. As an alternative, many States adopt the
approach of calculating the percentage of support on the basis of those parties
actually participating in the voting on the basis that absentees and abstaining
voters can be considered to have little interest in the proceedings. This
approach may result in a potentially small and unrepresentative group of credi-
tors affecting the course of the reorganization, in particular in view of the
prevalence of creditor apathy. A balanced approach that facilitates approval of
the plan and ensures a sufficient level of creditor support is required to enable
implementation and avoid abuse. This can be facilitated, whichever of the
approaches discussed above is adopted, by requiring provision of adequate
notice to creditors and other parties in interest, especially where they are non-
residents, as well as by adopting mechanisms to facilitate and encourage more
widespread voting, such as the use of proxies and electronic means.

   (ii) Use of presumptions
33. Some insolvency laws also make use of presumptions to simplify voting
procedures. Where, for example, a plan cancels a creditor’s claim or an
owner’s equity interest (and that party receives nothing under the plan), a vote
by that party against the plan can be presumed. In contrast, where a plan does
not modify or affect a claim or provides that it will be paid in full, a vote in
favour of the plan can be presumed. The use of such presumptions may also
reduce the need to provide notice and information to relevant creditors and
other parties in interest.
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(c)         Approval by secured and priority creditors
      (i)     The need for secured and priority creditors to vote
34. In many cases of insolvency, secured claims will represent a significant
portion of the value of the debt owed by the debtor. Different approaches can
be taken to approval of the plan by secured and priority creditors. As a general
principle, however, the extent to which a secured creditor is entitled to vote
will depend upon the manner in which the insolvency regime treats secured
creditors, the extent to which a reorganization plan can affect the security
interest of the secured creditor and the extent to which the value of encum-
bered assets will satisfy the secured creditor’s claim.

35. Under one approach, where the insolvency law does not affect secured
creditors and, in particular, does not preclude them from enforcing their rights
against the encumbered assets, there is no need to give these creditors the right
to vote since their security interests will not be affected by the plan. Priority
creditors are in a similar position under this approach—the plan cannot impair
the value of their claims and they are entitled to receive full payment before
creditors without priority are paid. The limitation of this approach, however,
is that it may reduce the chances for a successful reorganization where the
encumbered assets or modification of the rights of such creditors are key to
the success of the plan. If the secured creditor is not bound by the plan, the
election by the secured creditor to enforce its rights, such as by repossessing
and selling the encumbered asset, may make reorganization of the business
impossible to implement. Similarly, there may be circumstances where ensur-
ing a successful reorganization requires that priority creditors receive less than
the full value of their claims upon approval of the plan. The prospects for
reorganization may improve if priority creditors will accept payment over time
and if secured creditors will acquiesce when the terms of the secured debt are
modified over time. If these creditors are not included in the plan and entitled
to vote on proposals affecting their rights, modification of those rights cannot
be achieved.

      (ii) Classes of secured and priority creditors
36. Recognizing the need for secured and priority creditors to participate, a
second approach provides for these creditors to vote as classes separate from
unsecured creditors on a plan that would modify or affect the terms of their
claims, or to otherwise consent to be bound by the plan. Adopting such an
approach provides a minimum safeguard for the adequate protection of these
creditors and recognizes that the respective rights and interests of secured and
priority creditors differ from those of unsecured creditors. In many cases,
however, the rights of secured and priority creditors will differ from each other
and it may not be feasible to require all secured creditors or all priority credi-
tors to vote in a single class. In such cases, some laws provide that each
secured creditor with separate rights to encumbered assets forms a class of its
own. Those laws also provide that, where secured creditors do vote as a class
(e.g. where there are multiple holders of bonds that are secured by the same
assets), the requisite majority of a class of secured creditors would generally
Part two:   IV. Reorganization                                                 221


be the same as that required for approval by unsecured creditors, although
there are examples of laws that require different majorities depending upon the
manner in which secured creditors rights are to be affected by the plan
(e.g. one law provides that a three-quarter majority is required where the
maturity date is to be extended and a four-fifths majority where the rights are
to be otherwise impaired). Similarly, each rank of priority claims would be a
separate class under those laws.

37. Where secured creditors vote in classes, some insolvency laws provide
that, to the extent the requisite majority of the class votes to approve the plan,
dissenting members of the class will be bound by the terms of the plan, subject
to certain protections. The insolvency law may provide, for example, that such
creditors will only be bound by the plan where they receive at least as much
as under the plan as they would have received in liquidation or, under some
laws, if the plan makes provision for them to be paid in full to the extent of
the value of their security interest within a certain period of time, together with
interest at a market rate. Other insolvency laws provide that the plan cannot be
imposed upon any secured creditors unless they consent to such imposition. A
similar dichotomy exists with respect to priority claims. Some laws permit
payment over time as long as the present value of the claim is preserved. Other
laws permit modification of priority claims only with the consent of the
priority creditors.

   (iii) Where secured creditors are not fully secured
38. To the extent that the value of the encumbered asset will not satisfy the
full amount of the secured creditor’s claim, a number of insolvency laws
provide that those secured creditors should vote with ordinary unsecured credi-
tors in respect of the unsatisfied portion of the claim. This may raise difficult
questions of valuation in order to determine whether, and to what extent, a
secured creditor is in fact secured. For example, where three creditors hold
security interests over the same asset, the value of that asset may only support
the claim first in priority and part of the second in priority. The second creditor
therefore may have a right to vote only in respect of the unsecured portion of
its claim, while the third creditor will be totally unsecured. The valuation of
the asset is therefore crucial to determining the extent to which these secured
creditors are secured and whether or not they are entitled to vote as unsecured
creditors with respect to any portion of their claim.

39. In determining which approach should be taken to this issue, it will be
important to assess the effect of the desired approach upon the availability and
cost of secured financing and to provide as much certainty and predictability
as possible, balancing this against the objectives of insolvency law and the
benefits to an economy of successful reorganization.

(d)   Approval by ordinary unsecured creditors
40. Different mechanisms may be used to ensure that ordinary unsecured
creditors can vote efficiently and effectively on approval of a plan. Whichever
222                                           UNCITRAL Legislative Guide on Insolvency Law


mechanism is chosen it is desirable that it be as simple as possible and clearly
set out in the insolvency law to ensure predictability and transparency.

      (i)    Classes of unsecured creditors
41. A number of insolvency laws do not provide for unsecured creditors to be
divided into different classes and they vote together as a single group.

42. States that have established classes for secured and priority creditors often
also provide for the division of ordinary unsecured creditors into different
classes based upon their varying economic interests. The creation of such
classes is designed to enhance the prospects of reorganization in at least three
respects, by providing a useful means of identifying the varying economic
interests of unsecured creditors; a framework for structuring the terms of the
plan and ensuring that all creditors in a class receive the same treatment; and
a means for the court to utilize the requisite majority support of one class to
make the plan binding on dissenting classes. Since the creation of different
classes has the potential to complicate the voting procedure, it may be
desirable only where there are compelling reasons for special treatment of
some ordinary unsecured creditors, such as where there is a large number of
creditors that lack a common economic interest and the treatment they are to
be to be offered under the plan differs. Criteria that may be relevant in deter-
mining commonality of interest may include the nature of the debts giving rise
to the claims; and the remedies available to the creditors in the absence of the
reorganization plan, including the extent to which the creditors could recover
their claims by exercising those remedies. Where there is a small number of
unsecured creditors or where their interests are similar, there may be no need
for voting on approval of the plan to be conducted in different classes, thus
simplifying the procedure.

      (ii) Determination of classes
43. Some insolvency laws specify the manner in which classes of ordinary
unsecured creditors or claims are determined for the purposes of approval of
the reorganization plan. One approach is for claims to be classified on the basis
of common or substantial similarity of interest or on the basis of value. Where
the test is commonality or similarity of interest, the party proposing the plan
may have some flexibility in assigning claims to a particular group. Other
approaches provide for the insolvency representative to make recommenda-
tions to the court before the creditors vote on approval or for the classes to be
determined in the first instance by the debtor, who will have some limited
flexibility as to the composition of each class; unsecured creditors who are
dissatisfied with the composition of the class can seek to have the issue
reviewed by the court.

(e)         Approval by equity holders
44. Some insolvency laws provide for a reorganization plan to be approved
by equity holders, at least where the corporate form, the capital structure or the
Part two:      IV. Reorganization                                             223


membership of the debtor will be affected by the plan. Equity holders may also
be expected to vote in cases where they will receive a distribution under the
plan. Where equity holders are entitled to vote, they should be provided with
the same notice and information as creditors entitled to vote. Where the
debtor’s management proposes a plan, the terms of the plan may already have
been approved by the equity holders (depending upon the structure of the
debtor in question, this may be required under its constitutive instrument). This
is often the case where the plan directly affects equity holders, such as through
debt-for-equity conversions, either by transferring existing shares or issuing
new shares.

45. In circumstances where the insolvency law permits creditors or an
insolvency representative to propose a plan, and the plan contemplates debt-
for-equity conversion, some States allow the plan to be approved by creditors
over the objection of equity holders, irrespective of the terms of the consti-
tutive instrument of the debtor. Such plans may result in the interests of
existing equity holders being entirely displaced in the new business without
their consent.

(f)         Related persons
46. Some insolvency laws provide that related persons should not vote with
other creditors on approval of the plan or that their votes will not count for
certain purposes, such as determining that an impaired class of creditors has
accepted the plan (when that is a requirement of approval). Many insolvency
laws, however, do not include provisions dealing specifically with this issue of
related persons. In such cases, related persons generally vote in the same
manner as other creditors. They will generally be subject, however, to the
provisions of non-insolvency law in respect of their personal dealings with the
debtor and its business.

(g)         Requirements for approval of the plan
47. Many insolvency laws identify the minimum threshold of support re-
quired from creditors for a plan to be approved. The requisite majority can be
calculated in a number of different ways, depending upon whether or not
creditors vote in classes and how those classes are treated in determining the
majority and, as already discussed, whether the insolvency law requires a
majority of creditors voting or of all creditors.

      (i)    Where voting is not conducted in classes
48. Where creditors do not vote in classes, the majority may be fixed by
reference to the support of a proportion or percentage of the value of claims
or a number of creditors, or a combination of both. Some laws require, for
example, that a plan be supported by at least two thirds or three quarters of the
total value of the debt and more than one half or two thirds of the number of
creditors. While these proportions generally apply to those creditors actually
voting on approval of the plan, there are laws that determine proportions by
224                                      UNCITRAL Legislative Guide on Insolvency Law


reference to the total value of debt and total number of creditors, irrespective
of whether or not they vote (see above, para. 32). Other combinations are
also used.


  (ii) Where voting is conducted by class
49. Where creditors vote in classes, a wide variety of different approaches are
taken to determining when a plan is approved. These approaches can be some-
what complex, involving requirements both for approval by a particular class
and for approval among all classes, with majorities determined by reference,
in some cases, only to those creditors actually voting and in others to the total
number of creditors, whether voting or not. Whichever approach is adopted, it
is important that it be set forth clearly in the insolvency law to provide
certainty and transparency for parties to reorganization proceedings.

      a.   Majority within a particular class
50. Some insolvency laws require a plan to be approved by a majority of
creditors of a class, where the requisite majority is based upon a percentage or
proportion of the value of claims or a number of creditors, or a combination
of both. Although increasing the difficulty of achieving approval, a procedure
that includes both value of claims and number of creditors may be justified on
the basis that it protects the collective nature of the proceedings. For example,
if a single creditor holds a majority of the value, such a rule prevents that
creditor from imposing the plan on all other creditors against their will.
Equally, such a provision may prevent a large creditor from imposing its lack
of support for the plan on other creditors to their detriment, although there are
examples of laws that give creditors holding more than a certain percentage of
the total value of claims a power to veto approval or to force an improvement
of the terms of the plan for the benefit of all creditors. A voting procedure that
combines the value of claims with a number of creditors will also prevent a
large number of creditors with small claims from imposing their decision on
a few creditors who hold very large claims. Some insolvency laws include
provisions to the effect that, even where a majority of the number of creditors
support a plan, if those creditors represent less than a certain percentage of
value of the total claims (e.g. around 25 or 30 per cent), the court may not
confirm the plan. This procedure may be justified on the basis that it helps to
ensure that the support for the plan is sufficient to enable it to be successfully
implemented.

      b.   Majority of classes
51. Some laws require that all classes of creditors must support the plan for
it to be approved. A few laws, however, enable support by some classes to
make the plan binding on other classes that do not support the plan. For
example, a simple majority of the classes may be required or, where less than
a majority of classes support the plan, the plan may nevertheless be made
binding on dissenting classes that do not support the plan, provided the court
Part two:   IV. Reorganization                                                225


is satisfied that certain conditions are met. One law, for example, divides
claims into three classes and provides that the plan must be approved by at
least two of those classes and that at least one of the approving classes would
not recover the full amount of their claims if the debtor were to be liquidated.
Another variation requires that at least one of the classes approving the plan
will have its rights modified or affected under the plan, to ensure that the plan
is not only supported by those creditors whose rights are not modified or
affected. Other laws provide that support by classes of unsecured creditors
cannot amount to approval of the plan if secured creditors oppose the plan.
Requirements for binding dissenting classes are discussed further in para-
graphs 54-63 below.


               6.    Where a proposed plan cannot be approved
(a)   Modification of a proposed plan
52. Whichever voting mechanism is chosen, it is desirable that the insolvency
law be sufficiently flexible to allow a plan submitted for approval to be nego-
tiated by creditors and other parties in interest in the course of the voting
procedure with a view to achieving wide support. Where such negotiation is
not possible and voting is restricted to the plan as proposed, the chances of
achieving approval of that plan may be reduced. Flexibility may be achieved
by allowing a majority of creditors to vote to adjourn the meeting convened to
vote on the plan if it appears that further negotiation on the plan may produce
a favourable result or that unresolved disputes and issues can be addressed. As
with many other provisions of the insolvency law, however, it is desirable that
any such an adjournment is available in limited circumstances or at least a
limited number of times, with perhaps time limits being included to facilitate
speedy resolution of the renegotiations and avoid abuse.


(b)   Failure to approve a plan
53. In cases where a reorganization plan is not approved and renegotiation
and modification of the plan will not resolve the difficulties encountered, an
insolvency law may adopt different approaches to the further conduct of the
proceedings. Some insolvency laws provide that the failure to obtain
approval of the plan should be taken as an indication that creditors favour
liquidation and the reorganization proceedings can be converted to liquida-
tion (see below, paras. 72-75). This approach may encourage debtors to
propose an acceptable plan, subject to safeguards to prevent abuse in cases
where liquidation is not in the interests of all creditors. Other insolvency
laws provide that the reorganization proceedings should be dismissed.
In many circumstances, this approach has the disadvantage of leaving the
debtor in a state of financial difficulty, where further debts may accrue and
the value of the assets diminish, and postponing the commencement of the
liquidation proceedings that may be inevitable (this approach is discussed
further below, see para. 71).
226                                       UNCITRAL Legislative Guide on Insolvency Law


                7.   Binding dissenting classes of creditors
54. As noted above, a few States that provide for voting on approval of a plan
by secured and priority creditors and for the creation of different classes of
unsecured creditors also include a mechanism that will enable the support of
one or more classes to make the plan binding on other classes (including, under
some laws, classes of secured and priority creditors) that do not support the
plan. This is sometimes referred to as a “cram-down” provision. Where
such provisions are incorporated into the insolvency law, the law also
generally includes conditions that are aimed at protecting the interests of those
dissenting classes of creditors. These conditions include that the requisite
approvals of the plan have been obtained and that the approval process was
properly conducted; that creditors will receive at least as much under the plan
as they would have received in liquidation proceedings; that the plan does not
include provisions contrary to the insolvency law or to other relevant law; that
administrative claims and expenses will be paid in full, except to the extent
that the holder of such a claim or expense has agreed to different treatment;
and that the claims of classes of creditors that do not support a plan are treated
under the plan in accordance with the rank accorded to them under the
insolvency law (in other words, that creditors in that class will be paid in full,
whether in money or property, such as stock or other securities, before a junior
rank is paid). Since it is generally the court that is required to consider whether
these conditions have been satisfied, they are discussed in the following
section.

55. Under some insolvency laws, the court has the power to order that secured
creditors are bound by the plan, provided it is satisfied as to certain conditions.
These conditions may include that enforcement of the security interest by
the secured creditor will have a material adverse effect on achieving the pur-
poses of the plan; that the security interests of the secured creditor will be
sufficiently protected under the plan; and that the position of the secured
creditor will not further deteriorate under or as a result of the plan (e.g. pay-
ments of future interest will be made and the value of the encumbered asset
securing the security interest will not be affected). Similar provisions permit
the court to bind priority creditors to the plan if they are to be paid the full
amount of their priority claim and interest that preserves the current value of
the claim.


                     8.   Court confirmation of a plan
56. Not all States require the court to confirm a plan that has been approved
by creditors; approval by the requisite majority of creditors is all that is re-
quired for the plan to become effective and dissenting creditors will be bound
by virtue of the operation of the insolvency law. In those systems, the court
will still have a role to play with regard to review of the plan where dissenting
creditors or other parties in interest, including the debtor, challenge the plan
itself or the means by which approval was procured. Other States require court
confirmation of the approval for the plan to become effective and binding.
Part two:   IV. Reorganization                                                 227


(a)   Challenges to approval of the plan
57. Many insolvency laws provide for the approval of the plan by creditors
to be challenged in the court. The manner in which a challenge will be heard
may depend upon the mechanism for making the plan effective. If court con-
firmation of the plan is not required, for example, dissenting creditors or other
parties in interest, including the debtor, may raise their challenge with the court
after the vote on approval. Where the insolvency law requires court confirma-
tion of an approved plan, a challenge may be made at the confirmation hearing.
The law will need to address the parties that may challenge approval of the
plan, and the timing of any challenge, in particular where the basis of the
challenge is fraud. In that case, any time limits to be established for challeng-
ing approval may need to refer to the time of discovery of the fraud. The law
will also need to address the consequences of a successful challenge to the
plan. It may permit, for example, further opportunities for consideration and
approval of a plan if that approach is appropriate for remedying the ground on
which the plan was challenged or provide for the proceedings to be converted
to liquidation.

58. A number of insolvency laws establish the grounds for challenging
approval of the plan. Examples of such grounds include that approval was
obtained by fraud (e.g. false or misleading information was given to creditors
and other parties in interest or material information was withheld with respect
to the reorganization plan or the financial affairs of the debtor); that there was
some irregularity in the voting procedure (e.g. related persons participated
where this is not permitted under the insolvency law or the resolution approv-
ing the plan was not consistent with the interests of creditors generally); that
there was some irregularity in the organization or conduct of the meeting at
which the vote was taken (e.g. adequate notice of the meeting was not given);
that the proposals contained in the plan were put forward for an improper
purpose or that the plan contains provisions contrary to law; that the plan is not
feasible (e.g. encumbered assets are required for successful implementation of
the plan, but secured creditors are not bound by the plan and no agreement has
been reached with relevant secured creditors concerning enforcement of their
security interests); that the plan does not satisfy the requirements for protection
of dissenting creditors within a class (e.g. they will not receive as much under
the plan as they would have received in liquidation); that the proposals unfairly
prejudice the interests of the objector; or that the treatment of claims in the
plan does not conform to the ranking of claims under the insolvency law
(unless there has been agreement to vary that ranking).

59. Since all creditors are likely to be prejudiced to some degree by reorgani-
zation proceedings, a level of prejudice or harm that exceeds the prejudice or
harm suffered by other creditors or classes of creditors would generally be
required to enable a creditor to successfully challenge approval on grounds of
prejudice or unfairness. Where the creditor challenging the plan voted in
favour of the plan, the grounds for challenge may be limited, for example, to
fraud and other impropriety.
228                                       UNCITRAL Legislative Guide on Insolvency Law


(b)   Steps required for court confirmation
60. Where the insolvency law requires the court to confirm a plan, it would
normally be expected to confirm the plan that has been approved by the
requisite majority of creditors (whether voting in classes or otherwise). As
noted above, some States enable the courts to play an active role in binding
creditors by making the plan enforceable upon a class of creditors that has not
approved the plan. This may require the court to undertake a role that is in the
nature of a legal formality; it does not require the court to examine the com-
mercial basis upon which creditors voted in support of the plan, but rather to
ensure that the approval of the plan was properly obtained (i.e. there is no
evidence of fraud in the approval process) and that certain conditions were
satisfied.

61. As noted above (para. 54), these conditions may be similar to, or the same
as, conditions relevant to challenges to approval of the plan: that those classes
of creditor objecting to the plan will share in the economic benefits of the plan;
that dissenting classes of creditors will receive as much under the plan as they
would have received in liquidation; that no creditor will receive more than the
full value of its claim; that normal ranking of claims under the insolvency law
is observed by the plan; and that similarly ranked creditors are treated equally.
Some insolvency laws permit classes of unsecured creditors that are not
entitled to priority to consent, by vote of the requisite majority of the class, to
ranking different from that applying to distribution in liquidation under the
insolvency law. A class of ordinary unsecured creditors that will not be paid
in full might consent, for example, to a distribution to a class of subordinated
claims or equity holders. Claims and expenses that are administrative claims
or are entitled to be paid in priority are generally required to be paid in full
for a reorganization plan to be confirmed, except to the extent that the holder
of the claim or expense agrees to different treatment. Some laws require the
court to assess additional matters, such as whether the plan can be considered
to be fair in respect of those classes whose interests are modified or affected
by the plan but which nevertheless have voted to approve the plan.

62. Some insolvency laws also give the court the authority to reject a plan on
the grounds that it is not feasible or impossible to implement from a practical,
rather than an economic, point of view. Such an approach may be justified, for
example, where secured creditors are not bound by the plan, but the plan does
not provide for full satisfaction of their secured claims. The court may reject
the plan in such a case if it considers that secured creditors will enforce their
rights against the encumbered assets, thus rendering the plan impossible to
perform. The risk of this occurring should be addressed in provisions relating
to preparation and approval of the plan.

63. The more complex the decisions the court is asked to make in terms of
approval or confirmation, the more relevant knowledge and expertise is re-
quired of the judges and the greater the potential for judges to interfere in what
are essentially commercial decisions of creditors to approve or reject a plan.
In particular, it is highly desirable that the law not require or permit the court
Part two:    IV. Reorganization                                               229


to review the economic and commercial basis of the decision of creditors
(including issues of fairness that do not relate to the approval procedure, but
rather to the substance of what has been agreed) nor that it be asked to review
particular aspects of the plan in terms of their economic feasibility, unless the
circumstances in which this power can be exercised are narrowly defined or
the court has the competence and experience to exercise the necessary level of
commercial and economic judgement. For these reasons, it is desirable that the
requirements for approval of the plan by creditors and confirmation by the
court be carefully designed to minimize potential problems of the kind
discussed here.

    9.      Effect of an approved and, where required, confirmed plan
64. Where the plan is approved by the requisite majority of creditors and
equity holders and, where required, confirmed by the court, insolvency laws
generally provide that it will bind all affected ordinary unsecured creditors,
including creditors who voted in support of the plan, dissenting creditors,
creditors who did not vote on the plan and equity holders. Some insolvency
laws also provide that the plan will bind directors and other parties as deter-
mined by the court. Some insolvency laws stipulate that the parties who are
bound will be prevented from applying to the court to have the debtor liqui-
dated (except in specific circumstances, such as where implementation fails or
the debtor fails to perform its obligations as required under the plan), to start
or continue legal proceedings against the debtor or to pursue enforcement
without approval of the court. Some laws also provide that once the plan is
approved by creditors and, where required, confirmed by the court, the
property of the insolvency estate returns to the control of the debtor for imple-
mentation of the plan (unless the plan provides otherwise) and the debtor may
obtain a discharge from debts and claims pursuant to the plan.

              10.    Challenges to a plan after court confirmation
65. Many of those insolvency laws that require confirmation by the court
provide for the plan to be challenged in the court subsequent to the confirma-
tion hearing (in some cases within a specified period of time). On the basis that
the court is required to be satisfied as to a number of conditions before con-
firming a plan, the grounds for challenge after confirmation would generally
be narrower than the grounds for challenge at the time of confirmation and be
limited, for example, to fraud. Where an insolvency law permits such a chal-
lenge after confirmation, it may be desirable to specify a period of time after
discovery of the fraud within which such a challenge can be brought and to
specify who may bring such a challenge. Where a challenge to a plan that has
already been confirmed is successful, an insolvency law may adopt different
options. For example, the plan may be set aside and the proceedings converted
to liquidation. Alternatively, the proceedings may be dismissed and the assets
returned to the debtor’s control. The latter approach does not resolve the
debtor’s financial difficulty and may simply delay commencement of liquida-
tion proceedings, leading to further diminution of the value of the debtor’s
230                                       UNCITRAL Legislative Guide on Insolvency Law


assets before those proceedings are finally commenced. In determining the
most appropriate action to be taken in those circumstances, consideration will
need to be given to the extent to which the plan has already been implemented,
how steps taken in the implementation, such as payments to creditors, are to
be treated and the extent to which the grounds upon which the plan was
successfully challenged can be addressed.


         11.   Amendment of a plan after approval by creditors
66. An insolvency law may include limited provision for a plan to be modi-
fied after it has been approved by creditors (and both before and after confir-
mation) if its implementation breaks down or it is found to be incapable of
performance, whether in whole or in part, and the specific problem can be
remedied. Of those insolvency laws which allow modification, some provide
for the plan to be modified only if the modifications proposed will be in the
best interests of creditors. Other laws provide that the plan can be modified if
circumstances warrant the modification and if the plan, as modified, continues
to satisfy the requirements of the insolvency law concerning, for example,
content, classes of creditors and notice to creditors. Generally, any party in
interest will be permitted to propose modification of a plan at any time. The
only limitation that may apply in terms of timing relates to court approval of
a modification. Such a requirement necessitates that the proceedings are still
open and the court retains jurisdiction. If proceedings are concluded after
approval (and confirmation) of a plan, approval of the proposed amendment by
affected creditors may be sufficient, unless some other requirement is imposed.

67. Depending upon the nature of the modification it may not be necessary to
obtain the approval of all classes of creditors, since in some cases obtaining
that approval may prove difficult. Alternative approaches may include permit-
ting small modifications to be approved by the court or by the creditors
affected by the modification; or requiring creditors who supported the plan to
be notified of proposed modifications and permitting them to object within a
specified period of time or otherwise be deemed to have accepted the modi-
fication. The same approaches may be taken to creditors who did not approve
the plan. Where the modification proposed is significant, the approval of all
creditors may be required. Those insolvency laws which require court confir-
mation of the plan may also require modifications to satisfy the rules or con-
ditions relating to confirmation. It is desirable that an insolvency law address
the consequences of failure to obtain the requisite approval for the proposed
modifications. These might be similar to those discussed above in respect of
failure of creditors to approve the plan and successful challenges to the plan,
taking into account the steps that may already have been taken in implement-
ing the plan and the treatment to be afforded to payments made, contracts
continued and so forth.

68. Whichever approach is adopted, it is desirable that the insolvency law
require relevant creditors (whether all creditors or only affected creditors) to be
notified of any proposed modification and specifies the party responsible for
Part two:   IV. Reorganization                                                                       231


giving that notice, as well as requiring information relevant to the failure of the
plan and the proposed modification to be disclosed.

                             12.     Implementation of a plan
69. Many plans can be executed by the debtor without the need for further
intervention or supervision by the court or the insolvency representative,
especially in the case of a debtor-in-possession reorganization. No further
intervention or supervision would generally be possible where the insolvency
law provides that the proceedings conclude once a plan becomes effective.
Under other laws that provide for the proceedings to conclude when the plan
has been fully implemented, it may sometimes be necessary for the implemen-
tation to be supervised or controlled by an independent person. Under several
insolvency laws the court has an ongoing role in supervision of the debtor after
approval of the plan, pending completion of its implementation. This may be
important where issues of interpretation of the performance or obligations of
the debtor or others arise. Some States provide for the court to authorize
continued supervision of the affairs of the debtor, to varying degrees, by a
supervisor or insolvency representative after approval of the plan. A further
approach permits creditors to appoint a supervisor or representative to oversee
implementation of the plan.

                            13.     Where implementation fails
70. Where the debtor defaults in performing its obligations under the plan or
implementation of the plan breaks down for some other reason, insolvency
laws provide for a variety of consequences. Some insolvency laws provide that
the court can terminate the plan and convert the proceedings to liquidation (see
below). Other laws provide that the plan will only be terminated in respect of
the specific obligation breached (it otherwise remains valid). The creditor
whose obligation is breached will not be bound by the plan and will have its
claim restored (in the event that it had agreed to receive a lesser amount under
the plan) to the full amount. In some cases, this will only occur where the
debtor has fallen significantly into arrears2 in the performance of its obligations
under the plan. In some States, the consequences of default may be set out in
the plan itself.

71. A further approach may be to regard the insolvency proceedings as at an
end and to allow creditors to pursue the remedies otherwise available under the
law. As already discussed, this approach may not resolve the financial difficul-
ties of the debtor, depending upon the stage reached in implementation of the
plan when it fails, and could lead to a race for assets that the commencement
of collective proceedings was intended to avoid. There may be situations,
however, where the appropriate course of action is to permit the court to close
proceedings and allow parties in interest to exercise their rights at law. An

      2
        In one law, this requires a demand from the creditor for payment of the due liability and failure
by the debtor to comply within a minimum period of time of at least two weeks.
232                                      UNCITRAL Legislative Guide on Insolvency Law


example might be where the remaining assets are fully encumbered and there
will be no distribution to unsecured creditors. In some circumstances, and
depending upon the stage reached in implementation of the plan, a compromise
approach may be to allow the proposal of a different plan by creditors within
a specified deadline and only in situations where no acceptable plan can be
prepared within that deadline would liquidation follow. It must be recognized
that a balance has to be achieved between different factors, including the
time required to negotiate a plan; achieving the best outcome for creditors;
ensuring that value is maximized; and the need for expeditious conduct of the
proceedings.


                       14.   Conversion to liquidation
72. A number of circumstances may arise in the course of a reorganization
proceeding when it will be desirable for an insolvency law to allow the pro-
ceedings to be converted to liquidation. The principal grounds for conversion
would be failure to propose or approve a reorganization plan; failure to
approve proposed modifications that are required for implementation of the
plan; failure to obtain confirmation (where confirmation by the court is
required); a successful challenge to an approved or confirmed plan; a majority
vote by a meeting of creditors to terminate reorganization proceedings; a
material or substantial default by the debtor of its obligations under the plan;
or failure of implementation for some other reason. Some of these circum-
stances will only be relevant to those systems where the court supervises
implementation of the plan and retains jurisdiction over the debtor after
approval.

73. It may also be appropriate to consider conversion where it is determined
that there is no reasonable likelihood of the business being successfully
reorganized; where it is apparent that the debtor is misusing reorganization
proceedings either by not cooperating with the insolvency representative or
the court (e.g. withholding information) or otherwise acting in bad faith
(e.g. making fraudulent transfers); where the business continues to incur losses
during the reorganization period; or where administrative expenses are not
paid. Some laws impose an obligation on the insolvency representative to
terminate administration of the reorganization proceedings as soon as it is
evident that reorganization will not be possible, in order to preserve value for
creditors. Including provisions in an insolvency law for conversion to liquida-
tion will provide predictability as to the ultimate resolution of the proceedings.
If conversion to liquidation requires a new application for commencement to
be made, rather than relying upon the original application as the basis for the
converted proceedings, it may lead to further delay and diminution of value.
Accordingly, consideration may need to be given to the procedural require-
ments for commencement and conduct of converted proceedings.

74. Where reorganization proceedings are converted to liquidation, an
insolvency law will also need to consider the status of any actions taken by
the insolvency representative prior to approval of the plan; the continued
Part two:    IV. Reorganization                                                      233


application of the stay, in particular to secured creditors if the insolvency law
contains a time limit calculated by reference to commencement; the treatment
of payments made in the course of the implementation of the plan prior to a
conversion; and the treatment of creditor claims that have been compromised
in the reorganization. Payments made in the course of the reorganization may
need to be protected from the operation of avoidance provisions. Claims that
have been compromised in the reorganization may be reinstated to full value
in any subsequent liquidation or may be enforceable only as compromised. The
issue of failure of implementation may also be addressed in the reorganization
plan, which may specify the rights of creditors in that event. Such an approach
simplifies the question of treatment of those claims and avoids potentially
difficult issues of applicable law.

75. Where the insolvency law permits conversion, a related question is how
conversion can be triggered—whether it should be automatic once certain
conditions are fulfilled or require application to the court by the insolvency
representative or other parties in interest. Because it is the party that, after the
debtor or its management, has the greatest knowledge of the debtor’s business,
and often learns at an early stage of the proceedings whether or not the
debtor’s business is viable, the insolvency representative can play a key role
in initiating conversion. In addition, it may be reasonable to allow creditors or
other parties in interest to request the court to convert the proceedings. The
court could also be given the power to convert on its own motion where certain
conditions are met.




                                  Recommendations 139-159

    Purpose of legislative provisions

            The purpose of provisions relating to the reorganization plan is:
         (a) To facilitate the rescue of businesses subject to the insolvency law,
    thereby preserving employment and, in appropriate cases, protecting invest-
    ment;
            (b) To identify those businesses which are capable of reorganization;
            (c) To maximize the value of the estate;
        (d) To facilitate the negotiation and approval of a reorganization plan
    and establish the effects of approval, including that the plan should bind the
    debtor, creditors and other parties in interest;
         (e) To address the consequences of a failure to propose an acceptable
    reorganization plan or to secure approval of the plan, including conversion of
    the proceedings to liquidation in certain circumstances; and
        (f) To provide for the implementation of the reorganization plan and the
    consequences of failure of implementation.
234                                                 UNCITRAL Legislative Guide on Insolvency Law




      Recommendations 139-159 (continued)
      Contents of legislative provisions
      Proposal of a reorganization plan (paras. 6-16)
           139. The insolvency law should specify that a plan may be proposed on
      or after the making of an application to commence insolvency proceedings or
      within a specified period of time after commencement of the insolvency
      proceedings:
           (a) The time period should be fixed by the insolvency law;
           (b) The court should be authorized to extend the time period in appro-
      priate circumstances.

           140. The insolvency law should specify that a plan may be proposed on
      or after the making of an application to commence insolvency proceedings or
      within a specified period of time after commencement of the insolvency
      proceedings: where liquidation proceedings are converted to reorganization
      proceedings, the insolvency law should also address the impact of conversion
      on time limits for proposal of a plan.

      Preparation of a disclosure statement (para. 23)
           141. The insolvency law should require a plan to be accompanied by a
      disclosure statement that will enable those entitled to vote on approval of the
      plan to make an informed decision about the plan. The party that prepares the
      plan should also prepare the disclosure statement.

      Submission of the plan and disclosure statement (para. 23)
           142. The insolvency law should provide a mechanism for submission of
      the plan and disclosure statement to creditors and equity holders.

      Contents of a disclosure statement (paras. 24 and 25)
           143. The insolvency law should specify that the disclosure statement
      include:3
           (a) A summary of the plan;
           (b) Information relating to the financial situation of the debtor, including
      assets, liabilities and cash flow;
           (c) Non-financial information that might have an impact on the future
      performance of the debtor;
          (d) A comparison of the treatment afforded to creditors by the plan and
      what they would otherwise receive in liquidation;
          (e) The basis upon which the business would be able to keep trading and
      could be successfully reorganized;


      3
        Where the insolvency representative does not prepare, or is not involved in the preparation of,
the plan and the statement, the insolvency representative should be required to comment on both
instruments. Information included in the disclosure statement should be subject to the obligations of
confidentiality, discussed in chapter III, recommendation 111 and paras. 28, 52 and 115.
Part two:    IV. Reorganization                                                         235




         (f) Information showing that, having regard to the effect of the plan,
    adequate provision has been made for satisfaction of all obligations included
    in the plan; and
         (g) Information on the voting mechanisms applicable to approval of the
    plan.

    Content of a plan (paras. 18-22)
        144. The insolvency law should specify the minimum contents of a plan.
    The plan should:
         (a) Identify each class of creditors and the treatment provided for each
    class by the plan (e.g. how much they will receive and the timing of payment,
    if any);
            (b) Detail the treatment of equity holders;
            (c) Detail the terms and conditions of the plan;
            (d) Identify the debtor’s role in implementation of the plan;
         (e) Identify those responsible for future management of the debtor and
    supervision of the implementation of the plan and indicate their affiliation with
    the debtor and their remuneration; and
            (f) Indicate how the plan will be implemented.

    Voting mechanisms (paras. 26-51)
         145. The insolvency law should establish a mechanism for voting on
    approval of the plan. The mechanism should address the creditors and equity
    holders who are entitled to vote on the plan; the manner in which the vote will
    be conducted, either at a meeting convened for that purpose or by mail or other
    means, including electronic means and the use of proxies; and whether or not
    creditors and equity holders should vote in classes according to their respective
    rights.

        146. The insolvency law should specify that a creditor or equity holder
    whose rights are modified or affected by the plan should not be bound to the
    terms of the plan unless that creditor or equity holder has been the given the
    opportunity to vote on approval of the plan.

         147. The insolvency law should specify that where the plan provides that
    the rights of a creditor or equity holder or class of creditors or equity holders
    are not modified or affected by a plan, that creditor or equity holder or class
    of creditors or equity holders is not entitled to vote on approval of the plan.

         148. The insolvency law should specify that creditors entitled to vote on
    approval of the plan should be separately classified according to their respec-
    tive rights and that each class should vote separately.

        149. The insolvency law should specify that all creditors and equity
    holders in a class should be offered the same treatment.
236                                            UNCITRAL Legislative Guide on Insolvency Law




      Recommendations 139-159 (continued)
      Approval by classes (paras. 49-51, 54 and 55)
           150. Where voting on approval of the plan is conducted by reference to
      classes, the insolvency law should specify how the vote achieved in each class
      would be treated for the purposes of approval of the plan. Different approaches
      may be taken, including requiring approval by all classes or approval by a
      specified majority of the classes, but at least one class of creditors whose
      rights are modified or affected by the plan must approve the plan.

           151. Where the insolvency law does not require a plan to be approved
      by all classes, the insolvency law should address the treatment of those classes
      which do not vote to approve a plan that is otherwise approved by the requisite
      classes. That treatment should be consistent with the grounds set forth in
      recommendation 152.


      Confirmation of an approved plan (paras. 56 and 60-63)
           152. Where the insolvency law requires court confirmation of an
      approved plan, the insolvency law should require the court to confirm the plan
      if the following conditions are satisfied:
          (a) The requisite approvals have been obtained and the approval process
      was properly conducted;
           (b) Creditors will receive at least as much under the plan as they would
      have received in liquidation, unless they have specifically agreed to receive
      lesser treatment;
            (c) The plan does not contain provisions contrary to law;
          (d) Administrative claims and expenses will be paid in full, except to the
      extent that the holder of the claim or expense agrees to different treatment; and
           (e) Except to the extent that affected classes of creditors have agreed
      otherwise, if a class of creditors has voted against the plan, that class shall
      receive under the plan full recognition of its ranking under the insolvency law
      and the distribution to that class under the plan should conform to that ranking.


      Challenges to approval (where there is no requirement for confirmation)
      (paras. 57-59)
           153. Where a plan becomes binding on approval by creditors, without
      requiring confirmation by the court, the insolvency law should permit parties
      in interest, including the debtor, to challenge the approval of the plan. The
      insolvency law should specify criteria against which a challenge can be
      assessed, which should include:
            (a) Whether the grounds set forth in recommendation 152 are satisfied;
      and
          (b) Fraud, in which case the requirements of recommendation 154 should
      apply.
Part two:    IV. Reorganization                                                               237




    Challenges to a confirmed plan (para. 65)
        154. The insolvency law should permit a confirmed plan to be chal-
    lenged on the basis of fraud. The insolvency law should specify:
         (a) A time limit for bringing such a challenge calculated by reference to
    the time the fraud is discovered;
            (b) The party that may bring such a challenge; and
            (c) That the challenge should be heard by the court.

    Amendment of a plan (paras. 52 and 66)
         155. The insolvency law should permit amendment of a plan and specify
    the parties that may propose amendments and the time at which the plan may
    be amended, including between submission and approval, approval and confir-
    mation, after confirmation and during implementation, where the proceedings
    remain open.

    Approval of amendments (paras. 67 and 68)
         156. The insolvency law should establish the mechanism for approval of
    amendments to a plan that has been approved by creditors. That mechanism
    should require notice to be given to the creditors and other parties affected by
    the proposed modification; specify the party required to give notice; require
    the approval of creditors and other parties affected by the modification; and
    require the rules for confirmation (where confirmation is required) to be satis-
    fied. The insolvency law should also specify the consequences of failure to
    secure approval of proposed amendments.

    Supervision of implementation (para. 69)
         157. The law may establish a mechanism for supervising implementation
    of the plan, which may include supervision by the court, by a court-appointed
    supervisor, by the insolvency representative or by a creditor-appointed
    supervisor.4

    Conversion to liquidation (paras. 72-75)
         158. The insolvency law should provide that the court may convert
    reorganization proceedings to liquidation where:
         (a) A plan is not proposed within any time limit specified by the law and
    the court does not grant an extension of time;
            (b) A proposed plan is not approved;
        (c) An approved plan is not confirmed (where the insolvency law
    requires confirmation);
            (d) An approved or a confirmed plan is successfully challenged; or



      4
        Where the proceedings involve a debtor in possession, or where the proceedings conclude on
approval of the plan, it may not be necessary to appoint a supervisor.
238                                               UNCITRAL Legislative Guide on Insolvency Law




      Recommendations 139-159 (continued)
           (e) There is substantial breach by the debtor of the terms of the plan or
      an inability to implement the plan.5
      Failure of implementation of a plan (paras. 70 and 71)
           159. The insolvency law may specify that where there is a substantial
      breach by the debtor of the terms of the plan or an inability to implement the
      plan, the court may close the judicial proceedings and parties in interest may
      exercise their rights at law.



                 B.     Expedited reorganization proceedings6
                                      1.   Introduction
76. As discussed in part one of the Legislative Guide, reorganization can take
one of several forms. These include informal (i.e. in the sense of being con-
ducted out of court) voluntary restructuring negotiations, which require little or
no court involvement and essentially depend upon the agreement of the parties
involved and reorganization proceedings conducted in accordance with the
insolvency law under the formal supervision of a court (referred to here as “full
reorganization proceedings”). The latter proceedings generally involve all
creditors of the debtor and a reorganization plan formulated and approved by
creditors and other parties in interest after commencement of the proceedings.
Reorganization may also include, however, proceedings commenced to give
effect to a plan negotiated and agreed by affected creditors in voluntary
restructuring negotiations that take place prior to commencement, where the
insolvency law permits the court to expedite the conduct of those proceedings
(referred to in this section as “expedited reorganization proceedings”).
77. Reaching agreement through voluntary restructuring negotiations is often
impeded by the ability of individual creditors to take enforcement action and
by the need for unanimous creditor consent to alter the repayment terms of
certain existing classes of debt. These problems are magnified in the context
of complex, multinational businesses, where it is especially difficult to obtain
consent from all relevant parties. To provide a negotiating framework that can
be agreed by all participants and facilitates the successful outcome of these
negotiations, INSOL International published a Statement of Principles for a
Global Approach to Multi-Creditor Workouts. The Principles are designed to
expedite negotiation and increase the prospects of success by providing
guidance to diverse creditor groups about how to proceed on the basis of some
common agreed rules.

       5
         This course of action is only available where the proceedings remain open during implemen-
tation: see chapter VI, paras. 18 and 19.
       6
         Because these proceedings are based on the agreement achieved in voluntary restructuring
negotiations, this section should be read in conjunction with part one, chapter II, paras. 2-18.
Part two:   IV. Reorganization                                                  239


78. Voluntary restructuring negotiations can also be impeded by a minority of
affected creditors who may refuse to agree to a solution that is in the best
interests of most creditors in order to take advantage of their position to extract
better terms for themselves at the expense of other parties (often referred to as
“holding out”). Where these hold-outs occur, the voluntary agreement can only
be implemented if the contractual rights of these dissenting creditors can be
modified without their consent. Under most existing legal systems, such a
modification of contractual rights requires the commencement of full reorgani-
zation proceedings under the insolvency law, involving all creditors and requir-
ing satisfaction of the provisions of the insolvency law governing the conduct
of such proceedings. Typically, timing is critical in business restructuring and
delay (usually inherent in full reorganization proceedings) can frequently be
costly or even fatal to achieving an effective solution.

79. These difficulties, as well as some of the costs, delays and procedural and
legal requirements often associated with full reorganization proceedings, can
be avoided where voluntary restructuring negotiations and expedited reorgani-
zation proceedings are used. These proceedings can provide a cost efficient
means of resolving a debtor’s financial difficulties, although their effectiveness
may depend upon certain preconditions, discussed in part one of the Legis-
lative Guide (see chap. II, paras. 2-18), being met. These conditions may
include that a significant amount of debt is owed to a limited number of main
banks or financial institution creditors; that creditors accept that it may be
preferable to negotiate an arrangement, as between the debtor and the finan-
ciers and also between the financiers themselves, to resolve the financial dif-
ficulties of the debtor; that there is a prospect of greater benefit for all parties
through the negotiation process than by direct and immediate resort to the
insolvency law (in part because the outcome is subject to the control of the
negotiating parties and the process is less expensive and can be accomplished
quickly without disrupting the debtor’s business); and that the debtor does not
need relief from trade debts or the benefits of formal insolvency, such as the
automatic stay or the ability to reject burdensome debts.

80. Notwithstanding the dependence upon such conditions, voluntary restruc-
turing negotiations and expedited reorganization proceedings can be valuable
tools in the range of insolvency solutions available to a country’s commercial
and business sector. Encouraging the use of such solutions need not stem from
the fact that a country’s formal insolvency system is poor, inefficient or unre-
liable, but rather from the advantages such solutions can offer as an adjunct to
purely formal insolvency proceedings, which deliver fairness and certainty.
Moreover, such solutions work best where there is the possibility that if the
negotiation process cannot be started or breaks down, there can be swift and
effective resort to the insolvency law.

                 2.    Creditors typically involved in voluntary
                            restructuring negotiations
81. As noted above (see part one, chap. II, paras. 14-16), it is not always
possible, or even necessary, to involve all creditors in voluntary restructuring
240                                       UNCITRAL Legislative Guide on Insolvency Law


negotiations. Typically these negotiations involve the debtor and one or more
classes of creditors, such as lenders, bond holders and equity holders. They
also frequently involve major non-institutional creditors, typically where these
creditors’ involvement in the debtor’s business is so considerable that an effec-
tive restructuring is not possible without their participation. These types of
creditor often find it advantageous to participate in the negotiations because
there is a potential to reduce the loss that they would otherwise suffer under
full reorganization proceedings.

82. The limited classes of creditors that would normally participate in volun-
tary restructuring negotiations make an agreement easier to accomplish than
full reorganization because the latter proceedings typically affect all claims.
Since it is usual in voluntary restructuring negotiations for certain types of non-
institutional and other creditors, such as trade creditors, to continue to be paid
in the ordinary course of business, these creditors are not likely to have any
objection to the proposed restructuring and do not need to participate in the
negotiations. Where, however, the rights of those creditors are to be modified
by the plan, their agreement to the proposed modifications would be required.


 3.   Proceedings to implement a voluntary restructuring agreement
83. An insolvency law can include, in provisions on commencement of
reorganization proceedings under the insolvency law, provisions for the court
to confirm a voluntary restructuring agreement and to expedite those proceed-
ings. Where it does so, consideration will need to be given to defining the
debtors to whom such provisions might apply and the parties that can be
affected by such expedited proceedings.

(a)   Eligible debtors
84. It is desirable that expedited reorganization proceedings be available on
the application of any debtor that is not yet eligible to commence proceedings
under the general reorganization provisions of an insolvency law, but is likely
to be generally unable to pay its debts in the future as they mature. Including
provisions in an insolvency law that permit such debtors to commence expe-
dited proceedings recognizes the need to address financial difficulty at an early
stage and allows advantage to be taken of a voluntary restructuring agreement
that a majority of affected creditors has approved. Commencing expedited
proceedings will ensure the protection of dissenting creditors under the
insolvency law. The jurisdictional requirements generally applicable to com-
mencement of insolvency proceedings would also apply (see part two, chap. I,
paras. 12-18).

85. An insolvency law may also provide that expedited proceedings to con-
firm a voluntary restructuring agreement are available to a debtor that is
already eligible to commence full proceedings under the insolvency law (see
part two, chap. I, paras. 23-31 and recommendations 15 and 16). Where the
insolvency law establishes an obligation to commence insolvency proceedings
Part two:   IV. Reorganization                                                 241


if the debtor meets specified criteria concerning its financial position (e.g. that
it is insolvent), it may be necessary to provide specifically that the commence-
ment of expedited proceedings satisfies this obligation. Alternatively, the insol-
vency law may provide a temporary moratorium that will enable the debtor to
avoid meeting those criteria (and thus avoid the sanctions for failure to meet
the obligation to apply for commencement), while still taking action to resolve
its financial difficulties.

(b)   Obligations affected
86. As noted above, the types of obligation typically involved in voluntary
restructuring negotiations relate to borrowed money indebtedness, both institu-
tional and public, whether secured or unsecured, and other similar financial
obligations. Secured debt could also be included in such negotiations with the
agreement of the secured creditors. Indebtedness held by other creditors, such
as trade creditors, priority creditors such as tax and social security authorities
and employees, is generally not included because of the difficulty of obtaining
the consent necessary to adjust their claims and they continue to be paid in the
ordinary course of business. However, such creditors could be included where
their rights are to be modified in the reorganization and the necessary majority
approvals can be obtained, provided all the relevant safeguards applicable
under the insolvency law are observed. The specific obligations to be affected
in any given case would be those identified in the plan that is to be confirmed
by the court in expedited proceedings.

(c)   Application of the insolvency law
87. An insolvency law that permits expedited proceedings will need to iden-
tify those provisions of the insolvency law applicable to full reorganization
proceedings that will apply, in particular if any changes are to be made in the
manner in which they apply. So, for example, the provisions that would
generally apply to expedited proceedings in the same manner as to full pro-
ceedings (unless specifically modified) might include provisions on application
procedures; commencement of the proceedings; notification of commencement
(which may be modified to limit notification to those creditors and equity
holders affected by the plan) and the content of the notice (which may need
to include information on claim verification, time and place for the court
hearing on confirmation of the plan, objections to confirmation of the plan and
impact of the plan on equity holders); application of the stay; requirements for
preparation of a list of all creditors (in order to inform the court and to provide
certainty as to who is affected by the plan and who is not); requirements for
approval of the plan (including provision of the plan and supporting informa-
tion to affected creditors, determination of classes of creditors, creditor com-
mittees, criteria and majorities required for approval); effect and confirmation
of the plan, including standards of treatment that protect the interests of
dissenting creditors; issues relating to implementation of the plan (including
failure of implementation) and discharge of claims. Where implementation of
a plan confirmed under expedited proceedings fails, the insolvency law will
need to consider the consequences of that failure and, in particular, whether
242                                      UNCITRAL Legislative Guide on Insolvency Law


they should be the same as for failure of plan approved in formal proceedings
(see above, paras. 70-75) and whether special provision should be made in
respect of payments already made in the course of implementation.

88. Provisions of the insolvency law that might not apply to expedited pro-
ceedings or might be modified to comply with the goal of expedited proceed-
ings would include those relating to appointment of the insolvency representa-
tive, unless the plan specifically provides for that appointment; submission and
verification of claims; requirements for notice to unaffected creditors; time
periods for plan approval (where such provisions are included in the
insolvency law); and voting on the plan (since this occurred before commence-
ment). A further and important exception to the application of the insolvency
law would be that, where it could be shown that confirmation of the plan was
likely, the court could authorize creditors not affected by the plan to continue
to be paid in the ordinary course of business.

  (i)   Application requirements
89. The application for commencement of expedited proceedings may need to
be somewhat different to an application for full reorganization proceedings to
take account of the different background considerations. The application could
include the negotiated plan and disclosure statement; information concerning
the negotiations that have already been conducted (including the members of
any creditor committee that may have been formed to facilitate the negotia-
tions), the pre-commencement solicitation of creditors and voting of affected
classes of creditors (demonstrating that the majorities specified under the
insolvency law for approval of a plan have been achieved in classes of affected
creditors); evidence that unaffected creditors continue to be paid in the ordi-
nary course of business and that the plan does not modify or affect their rights;
as well as the protections afforded under the plan to dissenting creditors within
accepting classes. An insolvency law would also need to address the question
of whether the application functions to automatically commence the proceed-
ings or whether the court will be required to consider the application; if court
consideration is required, it is desirable that the time for such consideration be
as brief as possible, in particular because the application is based upon a
negotiated agreement and delay will be detrimental not only to the debtor’s
business but also to implementation of the plan.

  (ii) Effects of commencement
90. While commencement of full reorganization proceedings generally affects
the debtor and all its creditors (unless certain classes are specifically excepted
from application of the insolvency law), the effects of commencement of
expedited proceedings will generally be limited to the debtor and individual or
classes of creditors and equity holders whose rights are to be modified or
affected by the negotiated plan. There may be circumstances, however, where
the court may determine that additional creditors or classes of creditors should
be included in those effects in order to ensure, for example, protection of the
insolvency estate.
Part two:   IV. Reorganization                                                   243


   (iii) Failure of implementation
91. As already discussed (see above, paras. 70 and 71), insolvency laws adopt
different approaches to the consequences of failure to implement a plan
approved by creditors and, where required, confirmed by the court. While the
consequences of failure of implementation of a plan confirmed by the court in
expedited proceedings might generally be expected to be the same as in the
case of full reorganization proceedings, the possibility of commencing expe-
dited proceedings before a debtor can satisfy the commencement standard for
full reorganization proceedings suggests that conversion to liquidation might
not be appropriate; it may be preferable for the insolvency law to leave credi-
tors free to pursue their rights at law.

(d)   Expedition of the proceedings
92. In order to take full advantage of the negotiated plan and avoid the delays
that may make that plan impossible to implement, an insolvency law may need
to consider how, in addition to recognizing the steps that have been completed
before commencement as noted above, expedited proceedings can be handled
more quickly than full reorganization proceedings. For example, if a plan and
other documentation that complies with the formal requirements of the insol-
vency law has been negotiated and is supported by a substantial majority, it
may be possible for the court to order an immediate meeting or hearing as
applicable, saving time and expense. It may also be possible for an exemption
to be granted from part of the formal proceedings. For example, if a plan has
been negotiated and agreed by a majority of creditors of a particular class—
typically the institutional creditors—sufficient to satisfy the voting require-
ments of the insolvency law for approval of a reorganization plan and the
rights of other creditors will not be modified or affected by the plan, it might
be possible for the court to order a meeting or hearing of that particular ap-
proving class of creditors only. Similarly, if the solicitation of votes of affected
classes of creditors has been conducted in compliance with applicable laws
governing such solicitation (including the disclosure requirements of appli-
cable securities laws), it should be possible for the court to dispense with any
post-commencement solicitation procedures.
93. Even where the insolvency law provides for expeditious treatment of eli-
gible cases, it is highly desirable that it not afford less protection for dissenting
creditors and other parties than the insolvency law provides those same parties in
full reorganization proceedings. The procedural requirements for such expedited
reorganization proceedings would therefore include substantially the same safe-
guards and protections as provided in full reorganization proceedings.
94. Other laws may need to be modified to encourage or accommodate both
voluntary restructuring negotiations and expedited reorganization proceedings.
Examples of such laws might include those which expose directors to liability
for trading during the conduct of voluntary restructuring negotiations; which
do not recognize obligations for credit extended during such a period or subject
those obligations to avoidance provisions; and which restrict conversion of
debt to equity.
244                                                UNCITRAL Legislative Guide on Insolvency Law




                                Recommendations 160-168

      Purpose of legislative provisions
           The purpose of provisions relating to insolvency procedures that combine
      voluntary restructuring negotiations and acceptance of a plan with an expe-
      dited procedure conducted under the insolvency law for court confirmation of
      that plan is:
           (a) To recognize that voluntary restructuring negotiations, which typi-
      cally involve restructuring of the debt due to lenders and other institutional
      creditors and major non-institutional creditors where their participation is cru-
      cial to the restructuring, but not involving all categories of creditor, is a cost-
      effective, efficient tool for the rescue of financially troubled businesses;
          (b) To encourage and facilitate the use of informal negotiation;
          (c) To develop a procedure under the insolvency law that will:
                (i) Preserve the benefits of voluntary restructuring negotiations
                    where a majority of each affected class of creditors agree to
                    a plan;
               (ii) Minimize time delays and expense and ensure that the plan
                    negotiated and agreed in voluntary restructuring negotiations
                    is not lost;
              (iii) Bind those minority members of each affected class of credi-
                    tors and equity holders who do not accept the negotiated plan;
              (iv) Be based upon the same substantive requirements, but short-
                    ened time periods, as reorganization proceedings under the
                    insolvency law, including essentially the same safeguards; and
           (d) To suspend, with appropriate safeguards, requirements in other laws
      that may prevent or inhibit the use of processes that delay the invocation of the
      insolvency law.7

      Contents of legislative provisions

      Commencement of expedited reorganization proceedings (paras. 84 and 85
      and chapter I, paras. 12-18 and recommendations 10-12 on jurisdiction)
          160. The insolvency law should specify that expedited proceedings can
      be commenced on the application of any debtor that:
          (a) Is or is likely to be generally unable to pay its debts as they mature;
           (b) Has negotiated a reorganization plan and had it accepted by each
      affected class of creditors; and
           (c) Satisfies the jurisdictional requirements for commencement of full
      reorganization proceedings under the insolvency law.




      7
        For example, requirements for unanimous consent for adjustment of indebtedness outside of
insolvency proceedings, liability for directors where the debtor continues to trade during the period
when the out-of-court negotiations are being conducted, that do not recognize obligations for credit
extended during such a period and that restrict conversion of debt to equity.
Part two:    IV. Reorganization                                                                  245




         161. The insolvency law may additionally specify that an expedited pro-
     ceeding can be commenced on the application of any debtor if:
            (a) The debtor’s liabilities exceed or are likely to exceed its assets; and
          (b) The requirements of recommendation 160, subparagraphs (b) and (c),
     are satisfied.

     Application requirements (para. 89)
          162. The insolvency law should specify that the following additional
     materials should accompany an application for commencement of expedited
     reorganization proceedings:
            (a)   The reorganization plan and disclosure statement;
          (b) A description of the voluntary restructuring negotiations that pre-
     ceded the making of the application for commencement, including the infor-
     mation provided to affected creditors to enable them to make an informed
     decision about the plan;
          (c) Certification that unaffected creditors are being paid in the ordinary
     course of business and that the plan does not modify or affect the rights or
     claims of unaffected creditors without their agreement;
          (d) A report of the votes of affected classes of creditors demonstrating
     that those classes have accepted the plan by the majorities specified in the
     insolvency law;
         (e) A financial analysis or other evidence that demonstrates that the
     plan satisfies all applicable requirements for reorganization; and
         (f)    A list of the members of any creditor committee formed during the
     course of the voluntary restructuring negotiations.

     Commencement
         163. The insolvency law should specify that the application for com-
     mencement will automatically commence the proceedings or that the court will
     be required to promptly determine whether the debtor satisfies the require-
     ments of recommendations 160 or 161 and if so, commence proceedings.

     Effects of commencement (para. 90)
            164. The insolvency law should specify that:
          (a) Provisions of the insolvency law that apply to full reorganization
     proceedings will also apply to expedited proceedings unless specified as modi-
     fied or not applicable;8



       8
         Provisions of the insolvency law that generally would not be applicable or that could be
modified would include full claim filing; notice and time periods for plan approval; the post-
commencement mechanics of providing the plan and disclosure statement to creditors and other
interested parties and for solicitation of votes and voting on the plan; appointment of an insolvency
representative (who generally would not be appointed unless required by the plan); and provisions on
amendment of the plan after confirmation. An exception to the provisions of the insolvency law
applicable to full reorganization proceedings would be that creditors not affected by the plan would
be paid in the ordinary course of business during the implementation of the plan.
246                                           UNCITRAL Legislative Guide on Insolvency Law




      Recommendations 160-168 (continued)

           (b) Unless otherwise determined by the court, the effects of commence-
      ment should be limited to the debtor, individual creditors and classes of
      creditors and equity holders whose rights are modified or affected by the plan;
           (c) Any creditor committee formed during the course of the voluntary
      restructuring negotiations should be treated as a creditor committee appointed
      under the insolvency law; and
           (d) A hearing on the confirmation of the plan by the court should be held
      as expeditiously as possible.


      Notice of commencement (para. 87 and chapter I, paras. 64-71
      and recommendations 22-25)
           165. The insolvency law should specify that notice of the commence-
      ment of expedited proceedings is to be given to affected creditors and affected
      equity holders. The notice should specify:
          (a) The amount of each affected creditor’s claim according to the debtor;
           (b) The time period for submitting a claim in a different amount if the
      affected creditor disagrees with the debtor’s statement of the claim and the
      place where the claim can be submitted;
           (c) The time and procedure for challenging claims submitted by other
      parties;
           (d) The time and place for the hearing on confirmation of the plan and
      for the submission of any objection to confirmation; and
          (e) The impact of the plan on equity holders.


      Confirmation of the plan (paras. 60-63 and 88 and recommendation 152)
          166. The insolvency law should specify that the court will confirm the
      plan if:
           (a) The plan satisfies the substantive requirements for confirmation of a
      plan in full reorganization proceedings, in so far as those requirements apply
      to affected creditors and affected equity holders;
           (b) The notice given and the information provided to affected creditors
      and affected equity holders during the voluntary restructuring negotiations was
      sufficient to enable them to make an informed decision about the plan and any
      pre-commencement solicitation of acceptances to the plan complied with ap-
      plicable law;
           (c) Unaffected creditors are being paid in the ordinary course of business
      and the plan does not modify or affect the rights or claims of unaffected
      creditors without their agreement; and
           (d) The financial analysis submitted with the application demonstrates
      that the plan satisfies all applicable requirements for reorganization.
Part two:   IV. Reorganization                                                       247




    Effect of a confirmed plan (para. 64)
         167. The insolvency law should specify that the effect of a plan con-
    firmed by the court should be limited to the debtor and those creditors and
    equity holders affected by the plan.


    Failure of implementation of a confirmed plan (paras. 70, 71 and 91)
         168. The insolvency law may specify that where there is a substantial
    breach by the debtor of the terms of the plan or an inability to implement the
    plan, the court may close the judicial proceedings and parties in interest may
    exercise their rights at law.
                V.        Management of proceedings
                     A.    Treatment of creditor claims
                               1.   Introduction
1. Claims by creditors operate at two levels in insolvency proceedings—
firstly, for purposes of determining which creditors may vote in the proceed-
ings and how they may vote (according to the class into which they fall and
the value of their claim, where that is a relevant factor) and, secondly, for
purposes of distribution. The procedure for submission of claims and their
admission is therefore a key part of the insolvency proceedings. Consideration
should be given to determining which creditors should be required to submit
claims and the types of claim that should be submitted. Those claims might
include, for example, all rights to payment that arise from acts of omissions of
the debtor prior to commencement of the insolvency proceedings, whether or
not they are mature, liquidated or unliquidated, fixed or contingent. Considera-
tion should also be given to the procedures applicable to the submission,
verification and admission of claims, the consequences of failure to submit a
claim and review of decisions concerning the admission of claims. An insol-
vency law should also address the effect of submission and admission of
claims, as this will be key to creditor participation. For example, submission
of a claim may entitle a creditor to participate at a first meeting of creditors,
while admission, or at least provisional admission, may be essential to enable
a creditor to vote on various matters in the proceedings.

                     2.    Submission of creditor claims
(a)   Creditors who may be required to submit claims
2. The principal issue with regard to deciding which creditors will be
required to submit a claim relates to the treatment of secured creditors, since
unsecured creditors (irrespective of whether the debt is contingent or liqui-
dated) are generally required to submit a claim (unless of course, the claims
procedure provides an alternative mechanism for verification and admission of
claims that does not require all creditors to submit claims—discussed below).

3. Under those insolvency laws which do not include encumbered assets in
the insolvency estate and allow secured creditors to freely enforce their secu-
rity interest against the encumbered assets, secured creditors may be excepted
from the requirements to submit a claim, to the extent that their claim will be
met from the value of the sale of the encumbered asset. To the extent that the
value of the encumbered asset is less than the amount of the secured creditor’s
claim, the creditor may be required to submit a claim for the unsecured portion

                                      249
250                                                UNCITRAL Legislative Guide on Insolvency Law


as an ordinary unsecured creditor. The value of the unsecured claim thus
depends upon the value of the encumbered asset and how it is determined, as
well as the time at which it is determined. Unless clear rules apply to valuation,
there is the potential for some uncertainty, in particular in terms of deciding
voting rights where they are calculated by reference to the value of claims.1

4. Another approach requires secured creditors to submit a claim for the total
value of their security interest irrespective of whether any part of the claim is
unsecured. That requirement is limited in some laws to the holders of certain
types of security interest, such as floating charges, bills of sale, or security over
chattels. Some of those jurisdictions which require all secured creditors to
submit a claim include serious consequences for those failing to do so (dis-
cussed below). Some insolvency laws also permit secured creditors to surren-
der their security interest to the insolvency representative and submit a claim
for its total value.2

5. The rationale of requiring secured creditors to submit claims is to provide
information to the insolvency representative as to existence of all claims, the
extent of the secured debt and the assets that might be subject to a security
interest, as well as the total amount of the outstanding debt. Whichever
approach is chosen, it is desirable that an insolvency law include clear rules on
the treatment of secured creditors for the purposes of submission of claims. It
also important, in particular where an insolvency law provides that the claims
procedure can affect the security rights of a secured creditor, that notification
of the commencement of proceedings include information regarding the sub-
mission, or failure to submit, secured claims. It is desirable, where secured
creditors are required to submit a claim, that the procedures for submission and
verification be generally the same as for unsecured creditors.

(b)       Limitations on claims that can be submitted
6. It has not been unusual in the past for insolvency laws to limit the types
of claim that could be submitted, excluding, for example, unliquidated tort
claims. More recently, however, there has been a trend towards widening the
definition of claims that can be submitted to include those unliquidated tort and
contract claims, as well as contingent claims. An insolvency law may also need
to address the treatment of claims of a non-monetary nature, such as a right to
performance of an obligation (e.g. delivery of specific property) or a non-
recourse loan.

7. Insolvency laws adopt different approaches to excluded claims. Under
some laws, the creditors holding those claims cannot participate in the proceed-
ings and have no recourse for collecting their debt from the debtor; their claim

      1
       On the valuation of encumbered assets, see chap. II, paras. 66-68.
      2
       The UNCITRAL Model Law on Cross-Border Insolvency (art. 14, para. 3) and the Guide to
Enactment (para. 111) note that under some laws a secured creditor who files a claim is deemed to
have waived the security interest or some of the privileges attached to the credit, while under other
laws failure to submit a claim has that result (see annex III).
Part two:    V. Management of proceedings                                      251


is effectively extinguished. Under other laws, however, alternative courses of
recovery are preserved and the claim can be can be pursued outside the insol-
vency proceedings. It is desirable that an insolvency law adopt a broad defi-
nition of claims that can be submitted and addressed in the context of the
insolvency proceedings. It should be noted, however, that expanding that defi-
nition has the potential to make the insolvency proceedings more complicated,
in particular when those claims have to be valued to enable submission and
admission, even on a provisional basis.

   (i)      Post-commencement debt
8. As a general principle, claims can only be submitted in respect of debt
incurred prior to commencement. The treatment of debt incurred after com-
mencement will depend on the nature of the proceedings and the provisions of
the insolvency law—many laws provide that such debts are payable in full as
costs of the proceedings.

   (ii) Types of excluded claim
9. For a variety of public policy reasons, an insolvency law may seek to
exclude certain types of claim from the insolvency proceedings. Examples
include foreign tax claims, fines and penalties, claims relating to personal
injury, claims relating to negligence and gambling debts. Some insolvency
laws provide that these claims can be submitted, but that they may be subject
to special treatment, such as subordination to other unsecured claims. It is
highly desirable that an insolvency law identify those claims which are to be
excluded from the insolvency proceedings or subjected to special treatment
(see below, paras. 45-49).

         a. Foreign tax claims
10. Foreign tax claims are currently excluded by many States and it is gen-
erally recognized that such exclusion does not violate the objective of equal
treatment of foreign and domestic creditors. Despite this general view, how-
ever, there are no compelling reasons why such claims cannot be admitted if
a State wishes to do so. Where foreign tax claims are admitted, they can be
treated in the same manner as domestic tax claims or as ordinary unsecured
claims. Article 13, paragraph 2, of the UNCITRAL Model Law on Cross-
Border Insolvency (see annex III) recognizes these different approaches and
provides that the principle of equal treatment of foreign and domestic creditors
is not affected by the exclusion of foreign tax and social security claims or by
their ranking on the same level as general claims without priority or lower, if
equivalent local claims have that lower ranking.

         b. Claims arising from illegal activity
11. Where gambling debts are treated as excluded claims it is generally on the
basis that they arise from an activity that is itself illegal. Rather than focusing
upon specific examples of claims that may be excluded as illegal, an
252                                               UNCITRAL Legislative Guide on Insolvency Law


insolvency law may exclude, as a general category, those claims which arise
from illegal activity and therefore are unenforceable.

            c.    Fines and penalties
12. With respect to fines and penalties, an insolvency law may distinguish
between those which are of a strictly administrative or punitive nature (such as
a fine imposed as the result of an administrative or criminal violation) and
those of a compensatory nature. It may be argued that the first category of fines
and penalties should be excluded on the basis that they arise from some wrong-
doing on the part of the debtor and unsecured creditors should not be made to
bear the burden of that wrongdoing by seeing a reduction in the assets avail-
able for distribution. In comparison, there would seem to be no compelling
reason for excluding the second category, in particular where it relates to
recompense for damage suffered by another party, except to the extent that
exclusion may also be justified as a means of increasing the assets available
to unsecured creditors. An alternative approach would be to admit claims
based on fines and penalties because otherwise they will remain uncollected.

(c)         Procedure for submission of claims
      (i)        Timing of submission of claims
13. To ensure that claims are submitted in a timely fashion and that the
insolvency proceedings are not unnecessarily prolonged, a flexible approach to
the submission of claims is desirable, allowing creditors to make their claims
not only by mail, but also e-mail and other appropriate means. Deadlines for
submission of claims also can be specified. There are generally three types of
approach to specifying deadlines. In the first, the insolvency law specifies that
claims must be submitted within a certain period of time after the effective date
of commencement of proceedings or by reference to some other specified
event in the proceedings. In other laws, the deadline is to be determined by the
court or insolvency representative, but within a range specified in the insol-
vency law, with examples ranging from 10 days to three months after a speci-
fied event, such as commencement of proceedings. The third approach is
reflected in insolvency laws that do not establish any deadlines for submission
and leave it up to the insolvency representative to determine the timing of
submission of claims or also provide for claims to be submitted at any time up
until some specified point in the proceedings, such as the final report and
accounting by the insolvency representative. Some insolvency laws also estab-
lish different time limits depending upon the method of notification of com-
mencement; where the creditor is a known creditor and receives personal
notification of the commencement of proceedings the time limit may be shorter
than where the creditor has to rely on public notification of commencement.

14. A key factor in determining any deadline for submission will be the
procedure for verification and admission of claims. If that process is required
to take place at a court hearing or a meeting of creditors convened for that
purpose, there is likely to be less flexibility with respect to the timing of the
Part two:   V. Management of proceedings                                      253


submission of claims and claims not submitted by the specified date before that
meeting or hearing will require a special hearing or meeting to be convened.
Where verification and admission is conducted by the insolvency representa-
tive, greater flexibility will be possible since there will not be the same need
to satisfy procedural requirements associated with convening meetings of
creditors or court hearings.

15. While deadlines may assist in ensuring that the claims process does not
impose unnecessary delay on the proceedings, they may operate to disadvan-
tage foreign creditors who in many cases may not be able to meet the same
deadlines as domestic creditors. To ensure the equal treatment of domestic and
foreign creditors and to take account of the international trend of abolishing
discrimination based upon the nationality of the creditor, it may be possible to
adopt an approach that either allows claims to be submitted at any time prior
to distribution or some other specified event in the proceedings or sets a time
limit that can be extended or waived where a creditor has good reason for not
complying with the deadline or where the deadline operates as a serious
impediment to a creditor.

16. Where a deadline is established (whether by the insolvency law, the court
or insolvency representative) and the claim is submitted late, causing costs to
be incurred, those costs could be borne by the creditor. Where claims can be
submitted at an advanced stage of the proceedings, an associated question to
be addressed is whether interim distributions can be made before all claims
have been submitted and, if so, whether creditors submitting their claims after
a distribution has been made can nevertheless participate in that distribution.
Some insolvency laws provide that such a creditor can only participate in
distributions occurring after submission of its claim, while others require the
insolvency representative to make provision at the time of the distribution for
creditors that have not yet submitted their claims.

   (ii) Burden of submitting and proving claims
17. Many insolvency laws place the burden of submitting and proving a claim
upon creditors. Generally they will be required to produce evidence, in some
cases by way of a standard claim form accompanied by supporting documen-
tation, as to the amount of the claim, the basis of the debt and any priority or
security interest claimed. Many laws also permit the insolvency representative
to request the creditor to provide additional information or documentation to
prove their claim; some laws also permit rejection of claims that have not been
properly proved. While admission may be assisted in some jurisdictions by
requiring claims to be submitted in the form of a declaration, such as an
affidavit, to which sanctions would attach in the event of fraud, the formalities
associated with such declarations in some jurisdictions have led to that practice
being abandoned.

18. As a means of shortening the claims procedure, a number of insolvency
laws permit claims to be admitted in specified circumstances without a
requirement for formal submission of proof by the creditor. Appropriate
254                                               UNCITRAL Legislative Guide on Insolvency Law


circumstances may include those where the insolvency representative is able to
ascertain from the debtor’s books and records the creditors that are entitled to
payment and the amount of the debt. Although in many insolvency cases the
books and records of the debtor may not be completely reliable, this method
of admission has the advantage of reducing the formalities associated with
verification and admission of claims and may be appropriate where the claims
are not disputed either by the debtor or other creditors (discussed further
below).

19. This approach may be facilitated by the preparation of a list of creditors
and claims at an early stage of the proceedings. Preparation of such a list by
the debtor takes advantage of the debtor’s knowledge about its creditors and
their claims and can give the insolvency representative an early indication of
the financial state of the business. An alternative approach could require the
insolvency representative to assist the debtor to prepare that list or the
insolvency representative to prepare the list. While the latter approach may
serve to reduce the formalities associated with the process of verification of
claims, it may add to costs and delay, since it relies upon the insolvency
representative being able to obtain accurate and relevant information from the
debtor. Once the list is prepared, it could be used to assess which creditors
claims could be admitted without formal proof and which creditors should be
invited to make their claims to the insolvency representative for purposes of
verification, as well as for the purposes of ensuring that all relevant creditors
have been considered in the claims process. The list could also be revised and
updated over time to provide not only an accurate indication of the level of
the debtor’s indebtedness, but also the status of verification and admission
of claims.

20. It is desirable that an insolvency law address the question of false claims
and provide appropriate sanctions for creditors and others who lodge claims
that prove to be false.


   (iii)   Formalities for submission of foreign claims
21. An issue of particular importance to foreign creditors is whether the claim
must be submitted in the language of the jurisdiction in which the insolvency
proceedings have commenced and whether the claim is subject to certain
formalities, such as notarization. To facilitate the access of foreign creditors,
it is desirable that consideration be given to whether these requirements are
essential or may be relaxed as in the case of other procedural formalities
discussed in respect of article 14 of the UNCITRAL Model Law on Cross-
Border Insolvency (see annex III).3 In other respects, it is desirable that foreign
claims be subject to the same procedures for verification and admission as
domestic claims.


      3
        See also EC Regulation 1346/2000, articles 40 and 41, concerning information to be provided
to creditors.
Part two:    V. Management of proceedings                                     255


   (iv) Conversion of foreign currency claims
22. Where the debtor has business activities in different countries, creditors
may have debt denominated in currencies other than that of the country of the
insolvency proceedings. For verification and distribution purposes, these
claims are normally converted into the domestic currency, although circum-
stances may exist in which conversion is not required. The date of conversion
may have been agreed in the contract between the debtor and creditor or it may
be set in the insolvency law by reference to a fixed time, such as the effective
date of commencement or any other point in the proceedings. Where there is
a time difference between the date of conversion and the date of distribution
(which could occur significantly later), any appreciation or depreciation of the
currency will affect the amount of the claim. Where the currency is relatively
stable, this fluctuation may not be significant. In times of severe currency
instability or fluctuation, however, the fluctuation could result in a creditor
being significantly disadvantaged in favour of other creditors or advantaged at
the expense of other creditors. In such circumstances, an insolvency law might
provide that a provisional conversion could be made at the effective date of
commencement for the purposes of voting and, where the exchange rate fluc-
tuates more than a given percentage (which is stipulated in the insolvency law)
in the period before distribution, the conversion will be made at the time of
distribution or an appropriate adjustment made to the earlier calculation.

   (v) Party authorized to receive claims
23. Insolvency laws generally adopt one of two approaches to the question of
to whom claims should be submitted. Some laws require the claim to be
submitted to the court, while others provide for claims to be submitted to the
insolvency representative. The basis for the difference generally relates to the
process of verification and the respective roles of the court and the insolvency
representative. Where the insolvency representative is responsible for verifica-
tion and admission of claims, creditors generally have a right of recourse to the
court to dispute issues relating to the value or priority accorded to the admitted
claim or to the denial of the claim.


(d)      Failure to submit claims required to be submitted
   (i)      Failure to submit within a stipulated time period
24. Insolvency laws adopt different approaches to claims required to be sub-
mitted under the insolvency law where any time limit specified for submission
is not met. Some laws adopt a flexible approach, providing that, notwithstand-
ing the application of a deadline, claims still can be submitted at any time up
to, for example, the insolvency representative’s final report and accounting in
liquidation, but the creditor must bear any additional costs associated with late
submission. One consequence of late submission may be that the creditor
cannot participate in interim distributions occurring before submission (or
admission) of the claim, although as noted above there are examples of laws
that permit the creditor to receive previous interim dividends once the claim
256                                      UNCITRAL Legislative Guide on Insolvency Law


has been admitted. A further consequence is the loss of the right to vote at
meetings of creditors, where submission of a claim is a prerequisite to that
participation.

25. Another approach to submission of claims adheres strictly to submission
deadlines and some laws provide that failure to submit a claim may result in
the debt being extinguished or security rights being waived or forfeited, pro-
vided the creditor received the prescribed notification of commencement and
the requirements for claim submission. Other laws require a creditor who has
failed to submit its claim by the deadline to petition the court for admission.
Where the court admits the claim, the creditor may be limited to sharing only
in future dividends.

26. While creditors should be given the widest possible opportunity to submit
their claim in insolvency proceedings and must therefore receive timely and
appropriate notice of commencement and the requirements for claim submis-
sion, the proceedings should not be delayed by creditors who are aware of the
need to submit and of the applicable deadlines, but nevertheless fail to do so
in a timely manner. This has the potential to increase the costs of the proceed-
ings and disadvantages other creditors. The consequences of failure to submit
should therefore be clearly specified and creditors made aware of them at the
time they are notified of the deadlines for submission.

  (ii) Failure to submit a claim before conclusion of the proceedings
27. The failure of a creditor to submit a claim before the final report and
accounting may lead to different results depending upon other provisions of an
insolvency law. For example, some of the insolvency laws that provide for a
discharge of the debtor upon conclusion of the insolvency proceedings also
provide that claims not submitted in the insolvency proceedings are forfeited.


                 3.   Verification and admission of claims
(a)   List of submitted claims
28. Many insolvency laws require the court or the insolvency representative,
depending upon requirements for submission, to prepare a list of submitted
claims, either after expiry of the deadline for submission of claims or on a
continuing basis in cases where there is no deadline or the deadline occurs later
in the proceedings. Where the insolvency law requires preparation of a list of
creditors as discussed above (see chap. III, paras. 23 and 49), the list of claims
would update that earlier list of creditors and form the basis of verification and
admission of claims, as well as notification of the receipt, admission or denial
of claims, depending upon the applicable admission procedure. Many insol-
vency laws provide that all identified and identifiable creditors are entitled to
receive notice of all claims that have been made, whether personally, by pub-
lication of notices in appropriate commercial publications or by filing a list
with the court. That notice will enable creditors, the debtor and interested
Part two:    V. Management of proceedings                                     257


parties to see what claims have been submitted and to object to any claims
listed (where this is permitted under the insolvency law).

(b)      Procedures for verification and admission
29. Verification involves not only an assessment of the underlying legitimacy
and amount of the claim, but also classification of a claim for purposes of
voting and distribution (e.g. secured or unsecured claims, priority claims and
so on).

   (i)      Deadline for verification and admission
30. In addition to establishing deadlines for the submission of claims, a
number of insolvency laws impose time limits for verification and admission
of claims, requiring that a decision be provided to creditors within a short
period, for example 30 days after the deadline for submission expires. Other
laws make no provision for time limits. A key factor in deciding whether an
insolvency law should impose time limits in this case is the procedure for
verification and whether admission requires a court hearing or a meeting of
creditors to be held or is conducted by the insolvency representative. Where a
court hearing or meeting of creditors is held, admission usually occurs at that
hearing or meeting, subject to resolution by the court of disputes arising from
challenges to claims. For reasons of transparency and certainty and to ensure
the efficient conduct of the proceedings without undue delay, it is desirable
that the decision on admission or denial be made in a timely manner, in
particular where admission will determine participation in the proceedings and
voting rights. However, as is generally the case with any consideration of the
need for a time limit and irrespective of the approach adopted for verification
and admission, the advantages of establishing a limit must be weighed against
the potential disadvantages of inflexibility and the need to ensure that the time
limit is properly observed.

   (ii) Admission procedure
31. Insolvency laws adopt a variety of approaches to the admission procedure,
involving differing degrees of complexity and levels of involvement by the
court, the insolvency representative and creditors, in some cases requiring
input from all of these at various times. When coupled with rights of appeal
and the difficulties associated with processing types of claim requiring valua-
tion, the complexity of the process has the potential to significantly interrupt
the conduct of the proceedings and cause delay that will affect other steps in
the proceedings. For these reasons, it is highly desirable that formalities be
minimized and that decision-making be as streamlined as possible.

         a. Admission by the insolvency representative
32. As noted above (para. 23), insolvency laws generally require claims to be
submitted to the insolvency representative or to the court. Many insolvency
laws provide that where the claim is to be submitted to the insolvency
258                                      UNCITRAL Legislative Guide on Insolvency Law


representative, the insolvency representative will verify the claims and decide
whether or not they should be admitted, whether in whole or in part, or require
special treatment, such as where they are claims by related persons. The credi-
tor will be notified of the insolvency representative’s decision and where the
claim is denied, or admitted only in part or subjected to special treatment, the
insolvency representative is generally required to provide reasons for that
decision (often required to be given in writing). A requirement to provide
written reasons will enhance the transparency of the procedure, as well as,
potentially, its predictability for creditors and facilitate review by the court
where an insolvency representative’s decision is contested. Some insolvency
laws also require, as already noted, the insolvency representative’s decisions
on admission of claims to be regularly updated on the list of claims that is filed
with the court or made public in some other way in order to facilitate consi-
deration by other creditors and the debtor. Where, following appropriate noti-
fication, the insolvency representative does not receive any objections to
claims that it proposes to admit, a number of insolvency laws provide that the
claim is deemed to be admitted.

33. Under other insolvency laws the insolvency representative is required to
convene a meeting of creditors to consider submitted claims on the basis of the
list it has prepared and provided to creditors. That list may be required to
include recommendations as to admission, value and priority of individual
claims. Where no objections to admission of claims are made at that meeting,
the insolvency laws adopting this approach typically provide that the insol-
vency representative’s recommendations are deemed under the insolvency law
to be approved or the claims are deemed to be admitted.


      b.   Admission by the court
34. Where claims are to be submitted to the court, the court will generally
convene the meeting or hearing at which claims are examined and a decision
made as to admission. A number of laws require claims to be submitted within
a certain number of days before the date fixed for the meeting and a provi-
sional list of admissions, prepared either by the court or by the insolvency
representative, to be provided to all creditors before the hearing or meeting.
Where no objections to admission of the listed claims are made at that meeting,
these claims are typically deemed under the insolvency law to be admitted.


      c.   Requirements for personal appearance of creditors
35. One issue that may be of concern to creditors, and in particular to foreign
creditors, is the requirement in some insolvency laws for them to attend in
person creditor meetings called for the purpose of considering claims in order
for their claims to be admitted. Such a requirement has the potential to frustrate
the goal of equal treatment of similarly situated creditors and to cause delay.
While there may be cases where appearance will be important, as a general rule
claims can be admitted on the basis of documentary evidence. It is therefore
desirable that an insolvency law not require that in all cases creditors must
Part two:   V. Management of proceedings                                      259


appear in person for their claim to be admitted, but rather that, as a general
rule, they can be admitted on the basis of documentary evidence.

   (iii) Automatic admission of claims
36. With a view to minimizing the formalities required for verification and
admission of claims, an alternative approach to those outlined above may be
to provide that claims outstanding at the time of commencement do not require
verification and can be admitted on an automatic basis unless the claim is
challenged. This approach will require some mechanism for determining the
existence, value and priority of claims. While not necessarily sufficient in all
cases for reasons of reliability and completeness, it may be appropriate to rely,
in the first instance, upon the books and records of the debtor and the list of
creditors to be prepared in the proceedings to identify all outstanding claims
and their notional value. Where those claims are not disputed, the claim might
be admitted without the creditor having to submit formal proof. Automatic
admission of claims in this manner may avoid many of the difficulties asso-
ciated with the need for a precise assessment of the situation at the outset of
the proceedings to enable creditors to participate in and vote at meetings held
at an early stage of the proceedings.

   (iv)     Provisional admission of claims
37. Creditor claims may be of two types: liquidated claims and unliquidated
claims where the amount owed by the debtor has not been determined at
the time the claim is to be submitted or cannot at present be determined
(e.g. because it is the subject of a court action that has not been finalized at
the time of commencement and may be subject to the stay). Such claims may
be either contractual or non-contractual in nature and may arise in respect of
both secured and unsecured claims. Claims may also be conditional, contingent
and not mature at the time of commencement (the latter would generally be
subject to a deduction for the unexpired period of time before maturity).

38. Where the amount of the claim cannot be, or has not been, determined at
the time the claim is to be submitted, many insolvency laws allow a claim to
be admitted provisionally, subject to giving it a notional value. Determining a
value for such claims raises a number of issues such as the time at which the
value is to be determined and whether it must be liquidated (in which case it
will need to be considered by a court) or estimated (which might be undertaken
by the insolvency representative, the court or some other appointed person).
Where a court is required to determine the issue, an associated question relates
to the court that will be appropriate (i.e. the insolvency court or some other
court) and how any delay in reaching a determination can be addressed in
terms of its effect on the conduct of the insolvency proceedings. The question
of valuation of unliquidated claims can have a significant impact on insolvency
proceedings where, for example, mass tort claims are involved. As to timing
of the valuation, many insolvency laws require it to refer to the effective date
of commencement of proceedings. Special rules may be required where pro-
ceedings are converted from one form of proceedings to another.
260                                       UNCITRAL Legislative Guide on Insolvency Law


39. An important reason for permitting provisional admission is to allow
creditors holding those claims to participate in the proceedings and, in particu-
lar, to vote on key issues, such as on approval of the reorganization plan or on
other issues requiring a decision by creditors.

40. Where an insolvency law permits provisional admission of claims, it may
be necessary to consider whether such claims will be subject, in the first
instance, to the same procedure as other claims. For example, where admission
involves a hearing before the court or a meeting of creditors to be called,
claims that might be provisionally admitted could be subject to that procedure
or they could first be admitted by the insolvency representative, without preju-
dice to the right of a dissenting party to dispute that claim, and be subject to
some procedure for approval at a later stage. Other issues requiring considera-
tion include whether, when creditors with provisionally admitted claims do
vote on a reorganization plan they can be bound, as minority creditors, by a
plan to which they have not agreed; whether creditors with provisionally
admitted claims are entitled to participate in distributions occurring before the
claim has been fully admitted; and, if a provisionally admitted claim is subse-
quently denied or admitted only in part, what effect that will have on decisions
in which that creditor has participated. Provisional admission of a claim will
generally entitle the creditor to participate in the proceedings to the same
extent as other creditors, except that they may not be entitled to participate in
distributions until the value of the claim is finally fixed and the claim admitted.
Where, however, the claim is ultimately not fully admitted, any previous votes
by the creditor in the proceedings may be discounted in proportion to the
admitted claim.

(c)   Disputed claims
41. Where an insolvency law allows a claim submitted in the insolvency
proceedings to be disputed, whether as to its value, priority or basis, it is
desirable that it also specify the parties that are entitled to initiate such a
challenge. Some laws allow claims to be disputed only by the insolvency
representative, while other laws permit parties in interest, including other
creditors and the debtor, to dispute a claim. Depending upon the procedures for
submission and admission of claims, the dispute may be raised with the insol-
vency representative or before or at the court hearing or creditors’ meeting
held to examine claims. Where such a meeting or hearing is held, the pre-
paration of a provisional list of admissions, either by the court or by the
insolvency representative, and the provision of that list to all creditors before
the hearing or meeting will facilitate the consideration of claims. Where claims
are disputed in the insolvency proceedings a mechanism for quick resolution
of the dispute is essential to ensure efficient and orderly progress of the pro-
ceedings. Provisional admission of such a claim, pending resolution of the
dispute, may minimize disruption to the proceedings and the claims procedure.
If disputed claims cannot be quickly and efficiently resolved, the ability to
dispute a claim may be used to frustrate the proceedings and create unneces-
sary delay. Most insolvency laws provide for disputes to be resolved by the
court to ensure finality of the decision.
Part two:       V. Management of proceedings                                  261


42. Where claims submitted in the proceedings are the subject of a dispute
outside of the insolvency proceedings, they may generally fall into one or other
of the categories of claims that may be provisionally admitted in the insolvency
proceedings, depending upon the nature of the claim, and pending resolution
of that dispute (subject to application of the stay—see chap. II, paras. 30-34
and 60-62).

(d)         Effects of admission of a claim
43. Admission of a creditor’s claim will establish the right of that creditor to
attend meetings of creditors and the amount for which the creditor is entitled
to vote at such meetings, whether on the election of an insolvency representa-
tive or approval of a reorganization plan or some other matter specified in the
insolvency law. It will also fix the amount and priority of the claim that the
insolvency representative must take into account in making a distribution to
creditors.

(e)         Set-off of mutual claims
44. As noted above (chap. II, paras. 204-207), a number of insolvency laws
make provision for mutual money obligations between the debtor and creditors
to be set-off in insolvency proceedings, provided certain conditions are met.
These may include, for example, requirements that the claims existed and were
due and payable at the effective date of commencement of the proceedings;
that the creditor acquired the claim without fraud or was not aware of the
financial situation of its debtor; that the creditor did not acquire the claim
during the suspect period; that the creditor has declared its intention to seek a
set-off to the insolvency representative; and that the claims were related. A
very few insolvency laws provide for mandatory set-off in insolvency, while
a number of other laws do not permit set-off on the basis that it violates the
pari passu principle. Where set-off is permitted, it will usually be taken into
account by the insolvency representative or the court when verifying and
admitting claims.

(f)         Claims requiring special treatment
      (i)     Administrative claims
45. As noted above (chap. III, paras. 31, 66 and 112), insolvency proceedings
often require the assistance of professionals, such as the insolvency representa-
tive and advisors to the debtor or insolvency representative. Expenses may be
incurred by creditor committees, for the purposes of operating the business of
the debtor, including many or all post-commencement debts, such as claims of
employees, lease costs and similar claims, and in otherwise carrying out the
proceedings.

46. Notwithstanding the importance of providing appropriate remuneration to
those involved in the conduct of the insolvency proceedings, administrative
expenses have the potential to make a significant impact on the value of the
262                                      UNCITRAL Legislative Guide on Insolvency Law


insolvency estate. While to some extent that impact will depend upon the
design of an insolvency law and its supporting infrastructure, consideration of
how that impact can be minimized may be desirable. An insolvency law can
provide, for example, precise but flexible criteria relating to the allowance of
such expenses. Those criteria may include allowing expenses on the basis of
the utility of the expense to increasing the value of the estate for the general
benefit of all constituents or on the basis that they are not only reasonable and
necessary, but also consistent with the key objectives of the process. Reasona-
bleness of the expense may be assessed by reference to the amount of re-
sources available to the proceedings and to the possible effect of the expense
on the proceedings.

47. Different approaches may be taken to conducting that assessment. One
approach may be to require authorization by the court prior to the cost being
incurred or authorization by the court of all costs falling outside the scope of
the ordinary course of business. Another approach may be to require creditors
to make the assessment, in order to facilitate the transparency of the proceed-
ings, subject to recourse to the court in the event that the assessment of the
creditors is disputed. As noted above with respect to the remuneration of the
insolvency representative (see chap. III, para. 53), any mechanism adopted for
assessment of expenses should avoid a situation where a party or the parties
assessing the expenses can unduly influence the conduct of proceedings.

  (ii) Claims by related persons
48. A category of creditors that may require special consideration is those
persons related to the debtor, whether in a familial or business capacity (dis-
cussed above, see chap. II, para. 183, and below, para. 77). Special treatment
of the claims of these persons is often justified on the basis that they are more
likely than other creditors to have been favoured and to have had early knowl-
edge of the financial difficulties of the debtor. While they do not properly fall
within classes of excluded claims, it may be appropriate to consider whether
they should be admitted and treated in the same way as other creditors or be
admitted subject to special treatment. The mere fact of a special relationship
with the debtor, however, may not be sufficient in all cases to justify special
treatment of a creditor’s claim. In some cases these claims will be entirely
transparent and should be treated in the same manner as similar claims made
by creditors who are not related persons; in other cases they may give rise to
suspicion and will deserve special attention. An insolvency law may need to
include a mechanism to identify those types of conduct or situation in which
claims will deserve additional attention, such as where the debtor is severely
undercapitalized (e.g. where an office holder of the debtor has advanced funds
to the company in the form of a loan when the company is undercapitalized
and continues to trade without sufficient funds to pay creditors) or where there
is evidence of self-dealing (i.e. that the related persons have taken advantage
of their position to obtain a benefit, e.g. where six months before liquidation
the principal agrees to a compensation package that the company cannot pay
and files a claim for it in the liquidation). In those cases, the amount of the
claim that is admitted may be reduced, the claim can be subordinated to the
Part two:    V. Management of proceedings                                             263


claims of other classes of creditors (see below, paras. 55-61) or the voting
rights of the related creditor can be restricted with respect to certain issues
(such as in selection of the insolvency representative, where the insolvency law
allows creditors that choice).

   (iii) Claims for interest
49. Different approaches are taken to the accrual and payment of interest on
claims. Some insolvency laws provide that interest on claims ceases to accrue
on all unsecured debts once liquidation proceedings have commenced, but that
payment in reorganization will depend upon what is agreed in the plan. Other
insolvency laws provide that interest may accrue, but payment will be given
a low priority, such as after the payment of all unsecured creditors.

                               4.   Claims not admitted
50. Many insolvency laws provide that where a claim is denied, the creditor
concerned will have a right to seek review of that decision, whether it was
made by the court or the insolvency representative, within a specified period
of time after notification of the decision. Examples include time periods of
between 10 and 45 days.




                               Recommendations 169-184

     Purpose of legislative provisions

            The purpose of provisions on creditor claims is:
          (a) To define the claims that can or are required to be submitted and the
     treatment to be accorded to those claims;
          (b) To enable persons who have a claim against a debtor to submit
     claims against the estate;
            (c) To establish a mechanism for verification and admission of claims;
            (d) To provide for review of disputed claims; and
            (e) To ensure that similarly ranked creditors are treated equally.

     Contents of legislative provisions
     Requirement to submit (paras. 1 and 13)
          169. The insolvency law should require creditors who wish to participate
     in the proceedings to submit a claim, which should specify the basis and
     amount of the claim. The law should minimize the formalities associated with
     submission of claims. The insolvency law should permit claims to be submit-
     ted using different means, including mail and electronic means.
264                                                  UNCITRAL Legislative Guide on Insolvency Law




      Recommendations 169-184 (continued)

      Undisputed claims (paras. 17-19, 35 and 36)
           170. The insolvency law may permit claims that are undisputed to be
      admitted by reference to the list of creditors and claims prepared by the debtor
      in cooperation with the insolvency representative4 or the court or the insol-
      vency representative may require a creditor to provide evidence of its claim.
      The insolvency law should not require that in all cases a creditor must appear
      in person to prove its claim.

      Claims that may be submitted (para. 1)
           171. The insolvency law should specify that claims that may be submitted
      include all rights to payment that arise from acts or omissions of the debtor5 prior
      to commencement of the insolvency proceedings, whether mature or not,
      whether liquidated or unliquidated, whether fixed or contingent. The law should
      identify claims that will not be affected by the insolvency proceedings.6

      Secured claims (paras. 2-5)
          172. The insolvency law should specify whether secured creditors are
      required to submit claims.

      Equal treatment of similarly ranked creditors (paras. 10 and 21)
           173. The insolvency law should specify that all similarly ranked credi-
      tors, regardless of whether they are domestic or foreign creditors, are to be
      treated equally with respect to the submission and processing of their claims.

      Timing of submission of claims (paras. 13-16)
           174. The insolvency law should specify the period of time after the effective
      date of commencement of proceedings within which claims may be submitted.
      That time period should be adequate to allow creditors to submit their claims.7

      Consequences of failure to submit a claim (paras. 24-27)
           175. Where the insolvency law requires a creditor to submit a claim, the
      insolvency law should specify the consequences of failure to submit a claim
      within any period of time specified for submission.



      4
         See recommendation 110.
      5
         This would include claims by third parties or a guarantor for payment arising from acts or
omission of the debtor.
       6
         Some insolvency laws provide, for example, that claims such as fines and penalties and taxes
will not be affected by the insolvency proceedings. Where a claim is to be unaffected by the insol-
vency proceedings it would continue to exist and would not be included in any discharge.
       7
         Where proceedings involve foreign creditors, longer time periods may be required to facilitate
submission of claims. Also, it is desirable that claims be submitted at an early stage of the proceedings
so that the insolvency representative will be aware of the claims involved, of the encumbered assets
affected and of the value of those assets and claims.
Part two:   V. Management of proceedings                                                     265




     Foreign currency claims (para. 22)
          176. Where claims are denoted in foreign currency, the insolvency law
     should specify the circumstances in which those claims must be converted and
     the reasons for conversion. Where conversion is required, the insolvency law
     should specify that the claim will be converted into local currency by reference
     to a specified date, such as the effective date of commencement of insolvency
     proceedings.

     Admission or denial of claims (paras. 29-40)
          177. The insolvency law should permit the insolvency representative to
     admit or deny any claim, in full or in part.8 Where the claim is to be denied
     or subjected to treatment under recommendation 184 as a claim by a related
     person, whether in full or in part, notice of the reasons for the decision should
     be given to the creditor.

     Unliquidated claims (para. 38)
          178. The insolvency law should permit unliquidated claims to be admit-
     ted provisionally, pending determination of the amount of the claim by the
     insolvency representative.

     Valuation of secured claims (para. 38)
          179. The insolvency law should provide that the insolvency representa-
     tive may determine the portion of a secured creditor’s claim that is secured and
     the portion that is unsecured by valuing the encumbered asset.

     Disputing a claim (para. 41)
          180. The insolvency law should permit a party in interest to dispute any
     submitted claim, either before or after admission, and to request review of that
     claim by the court.

     Review of claims denied or subjected to special treatment
     (paras. 32, 33 and 48)
          181. The insolvency law should permit creditors whose claims have
     been denied or subjected to treatment under recommendation 184 as a claim
     by a related person, whether in full or in part, to request the court to review
     their claim. The insolvency law may specify a period of time after notification
     of the decision within which that request may be made.

     Provisional admission of disputed claims (para. 41)
          182. The insolvency law should specify that, claims disputed in the
     insolvency proceedings could be admitted provisionally by the insolvency
     representative pending resolution of the dispute by the court.


      8
        In some jurisdictions, the court may be required to ratify the decision of the insolvency
representative.
266                                                  UNCITRAL Legislative Guide on Insolvency Law




      Recommendations 169-184 (continued)

      Effects of admission (para. 43)
           183. The insolvency law should specify the effects of admission, includ-
      ing provisional admission, of a claim. These effects may include:
          (a) Entitling the creditor to participate in the proceedings and to be
      heard;
          (b) Permitting the creditor to vote at a meeting of creditors, including on
      approval of a plan;
           (c) Determining the priority to which the creditor’s claim is entitled;
           (d) Determining the amount for which the creditor is entitled to vote;
           (e) Except in the case of provisional admission of a claim, permitting the
      creditor to participate in a distribution.9

      Claims by related persons (para. 48)
          184. The insolvency law should specify that claims by related persons
      should be subject to scrutiny and, where justified:10

           (a) The voting rights of the related person may be restricted;
           (b) The amount of the claim of the related person may be reduced; or
           (c) The claim may be subordinated.11




                   B.    Priorities and distribution of proceeds
                                          1.     Priorities
(a)    Introduction
51. There are many diverse and competing interests in insolvency proceed-
ings. For the most part, creditors are creditors by virtue of having entered into
a legal and contractual relationship with the debtor prior to the insolvency.
There are creditors, however, who have not entered into such an arrangement
with the debtor, such as taxing authorities (who will often be involved in
insolvency proceedings) and tort claimants (whose participation generally will
be less common). Accordingly, the rights of creditors will be governed by a
number of different laws.

      9
        However, when making a distribution, the insolvency representative may be required to take
account of claims that have been provisionally admitted, or submitted but not yet admitted.
      10
         Sufficient justification may involve situations where the debtor is undercapitalized or there has
been self-dealing, as noted above, para. 48.
      11
         On subordination, see below, paras. 55-61.
Part two:   V. Management of proceedings                                       267


52. While many creditors will be similarly situated with respect to the kinds
of claims they hold based on similar legal or contractual rights, others will
have superior claims or hold superior rights. For these reasons, insolvency laws
generally rank creditors for the purposes of distribution of the proceeds of the
estate in liquidation by reference to their claims, an approach not inconsistent
with the objective of equitable treatment. To the extent that different creditors
have struck different commercial bargains with the debtor, the ranking of
creditors may be justified by the desirability for the insolvency system to
recognize and respect the different bargains, preserve legitimate commercial
expectations, foster predictability in commercial relationships and promote the
equal treatment of similarly situated creditors. Establishing a clear and predict-
able ranking system for distribution can help to ensure that creditors are certain
of their rights at the time of entering into commercial arrangements with the
debtor and, in the case of secured credit, facilitate its provision.

53. There is, however, a limit on the extent to which these goals can be
achieved. In addition to rankings based upon commercial and legal relation-
ships between the debtor and its creditors, distribution policies also very often
reflect choices that recognize important public interests (such as the protection
of employment), the desirability of ensuring the orderly and effective conduct
of the insolvency proceedings (providing priority for the remuneration of
insolvency professionals and the expenses of the insolvency administration)
and promoting the continuation of the business and its reorganization (by
providing a priority for post-commencement finance). To the extent that these
broader public interests compete with private interests, they may lead to a
distortion of normal commercial incentives. Where public interests are given
priority and equality of treatment based upon the ranking of claims is not
observed, it is desirable that the policy reasons for establishing that priority be
clearly stated in the insolvency law. In the absence of equality of treatment,
this approach will at least provide an element of transparency and predictability
in the area of claims, distribution and the establishment of creditor classes
under a reorganization plan.

54. Insolvency laws adopt a wide variety of different approaches to the
ranking of creditors, both in terms of priorities between different ranks and in
terms of the treatment of creditors within a particular rank, for example those
creditors broadly defined as “unsecured”, where different sub-ranks may be
employed.


(b)   Subordination of claims
55. When a natural person or organization owes debts to more than one
creditor, the priority scheme established in the applicable law (which may
provide for subordination of certain types of claim, for example, those of
related persons) or by agreement between the parties will determine the order
in which those debts should be paid. Even where a priority scheme is in place,
however, a creditor with a higher priority may be paid after one with a lower
priority because of subordination.
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56. Subordination refers to a rearranging of the creditors’ priorities and does
not relate to the validity or legality of a claim. A subordinated claim may be
valid and enforceable, but, because of an agreement or a court decision, it will
be paid later in the distribution scheme than it would otherwise be paid.
Subordination by agreement and by operation of law are discussed below.

  (i)   Contractual subordination
57. Contractual subordination occurs when two or more creditors of a single
debtor enter into an agreement (referred to as a “subordination” or “distribution
agreement”) that provides that one creditor agrees to receive payment on its
claim against the debtor after the payment of the other creditor or creditors.
These agreements may be between secured creditors or between unsecured
creditors. If between secured creditors, the agreement usually provides that one
creditor receives priority over the holder of an otherwise senior security
interest. Agreements between unsecured creditors typically provide that one
creditor will receive payment in full on its claim before the subordinated
creditor receives any distribution.

58. Subordination agreements can arise in different contexts. For example,
debenture holders typically agree to subordinate their claims to the debtor’s
working capital lender. Also, when a business is in financial distress, certain
creditors may agree to subordinate their claims in order to aid the business’s
reorganization efforts. Some creditors may agree to subordinate themselves to
a lender injecting new money into the business in the hope that the new money
will help the business recover and, thus, improve the prospects of the sub-
ordinated creditors being paid in full (see chap. II, paras. 94-107, on post-
commencement finance).

59. The laws that determine contract validity and enforceability also apply to
subordination agreements, as do the normal contract defences such as lack of
consideration, fraud and unconscionability. The general principle in insolvency
of recognizing pre-commencement priorities should be interpreted to include
priorities based upon a subordination agreement, provided that the agreement
is not to provide a ranking higher than would otherwise be accorded to the
particular creditor under the applicable law.

  (ii) Subordination by the court (referred to as
  “equitable subordination”)
60. This type of subordination occurs where a court has the power to change
the priority of payment of claims to prevent, for example, a creditor who has
committed fraud or some other illegal activity or acted inappropriately to gain
an advantage over other creditors from benefiting from that act. The doctrine
originally arose to prevent related persons from using legal mechanisms to
obtain advantages in priority.

61. Where this type of subordination is used, it will generally apply only if
the conduct under consideration actually results in some harm to other
Part two:      V. Management of proceedings                                     269


creditors, such as altering the normal distribution scheme and giving a creditor
an unfair priority position. The court could then use subordination to restore
the priority scheme so that a fair distribution occurs. If the conduct occurs, but
does not result in an unfair advantage, this type of subordination generally
cannot be used.

(c)         Ranking of claims
      (i)    Secured creditors
62. Many insolvency laws recognize the rights of secured creditors to have a
first priority for satisfaction of their claims, either from the proceeds of sale of
the specific encumbered assets or from general funds, depending on the manner
in which encumbered assets are treated. The method of distribution to secured
creditors depends on the method used to protect the secured creditor during the
proceedings (see chap. II, paras. 63-69). If the security interest was protected by
preserving the value of the encumbered asset, the secured creditor will
generally have a priority claim on the proceeds of the sale of that asset to the
extent of the value of its secured claim. Alternatively, if the security interest
was protected by fixing the value of the secured portion of the claim at the time
of the commencement of the proceedings, the creditor generally will have a
priority claim to the general proceeds of the estate with respect to that value.
Where the secured creditor’s claim is in excess of the value of the encumbered
asset or the value of the secured claim as determined at commencement (where
that approach is followed), the unsecured portion of the claim will generally be
treated as an ordinary unsecured claim for purposes of distribution.

63. Some insolvency laws do not afford secured creditors a first priority.
Payment of secured creditors may be ranked, for example, after costs of
administration and other claims, such as unpaid wage claims, tax claims,
environmental claims and personal injury claims, which are afforded the pro-
tection of priority under the insolvency law. Another approach is reflected in
laws that provide that the amount that can be recovered (in priority) by secured
creditors from the assets securing their claim is limited to a certain percentage
of that claim. In some of the laws that adopt that approach, a distinction is
made between security interests over essentially all of the assets of a business
(sometimes referred to as an enterprise mortgage or floating charge) and other
types of security interest, where only the former are subject to this exception.

64. The carved-out portion of the claim is generally used to serve the claims
of other creditors, whether lower ranking priority creditors or ordinary un-
secured creditors, or to pay the remuneration and expenses of the insolvency
representative and costs in connection with the preservation and administration
of the estate where the value of assets of the estate is insufficient to meet these
costs. One of the rationales of this approach is that the secured creditor should
share, in some equitable manner, some of the losses of other creditors in
liquidation and, in reorganization, some of the costs. It is suggested that, unless
some portion of the debtor’s assets are reserved for payment of those other
claims, it is unlikely that they will share in a distribution. The adoption of these
270                                       UNCITRAL Legislative Guide on Insolvency Law


types of exception to the rule of first priority of secured creditors has the
potential to create uncertainty with respect to the recovery of secured credit,
thus discouraging the provision of secured credit and raising the associated
costs. It is highly desirable that the use of such exceptions in an insolvency law
be limited.

65. Where the secured claim is satisfied directly from the net realization
proceeds of the asset concerned, the secured creditor, unlike unsecured credi-
tors, will generally not contribute (either directly or indirectly) to the general
costs of the insolvency proceeding, unless there are provisions such as noted
above. However, the secured creditor still may be required to contribute to
other costs directly related to its interests. If the insolvency representative has
expended resources in maintaining the value of the encumbered asset, it may
be reasonable to recover those expenses as administrative expenses from the
amount that would otherwise be paid in priority to the secured creditor from
the proceeds of the sale of the asset. A further exception to the first priority
rule may also relate to priorities provided in respect of post-commencement
finance, where the effect on the interests of secured creditors of any priority
granted should be clear at the time the finance is obtained, in particular since
it may have been approved by the secured creditors.

  (ii) Administrative costs and expenses
66. The administrative expenses of the insolvency proceeding often have
priority over unsecured claims and are generally accorded that priority to
ensure proper payment for the parties acting on behalf of the insolvency estate.
These expenses would generally include remuneration of the insolvency
representative and any professionals employed by the insolvency representa-
tive or in some cases the debtor; debts arising from the proper exercise of the
insolvency representative’s (or in some cases the debtor’s) functions and
powers; costs arising from continuing contract obligations (e.g. labour and
lease agreements); costs of the proceedings (e.g. court fees); and, under some
insolvency laws, the remuneration of any professionals employed by a
committee of creditors.

  (iii)   Priority or privileged claims
67. Insolvency laws often attribute priority rights to certain (mainly
unsecured) claims, which in consequence will be paid in priority to other,
unsecured and non-privileged (or less privileged) claims. These priority rights,
which are often based upon social, and sometimes political, considerations,
militate against the principle of pari passu distribution and generally operate
to the detriment of ordinary unsecured creditors by reducing the value of the
assets available for distribution to them. The provision of priority rights has the
potential to foster unproductive debate on the assessment of which creditors
should be afforded priority and the justifications for doing so. The provision
of these rights in an insolvency law also has an impact on the cost and avail-
ability of credit, which will increase as the amount of funds available for
distribution to other creditors decreases.
Part two:   V. Management of proceedings                                      271


68. Some priorities are based on social concerns that may be addressed more
readily by law other than the insolvency law, such as social welfare legislation,
than by designing an insolvency law to achieve social objectives that are only
indirectly related to questions of debt and insolvency. Providing a priority in
the insolvency law may at best afford an incomplete and inadequate remedy
for the social problem, while at the same time rendering insolvency proceed-
ings less effective. Where priorities are to be included in an insolvency law or
where priorities that exist in law other than insolvency law will be recognized
and have effect in insolvency proceedings, it is desirable that these priorities
be clearly stated or referred to in the insolvency law (and if necessary ranked
with other claims). This will ensure that the insolvency regime is at least
transparent and predictable as to its impact on creditors and will enable lenders
to assess more accurately the risks associated with lending.

69. In some recent insolvency laws there has been a significant reduction in
the number of these types of priority right, reflecting a change in the public
acceptability of such treatment. A few States, for example, have recently
removed the priority traditionally provided to tax claims. In others, however,
there is a tendency to increase the categories of debt that enjoy priority.
Maintaining a number of different priority positions for many types of claim
has the potential to complicate the basic goals of insolvency and to make
efficient and effective proceedings difficult to achieve. It may create inequities
and, in reorganization, complicates preparation of the plan. In addition, it
should be remembered that adjusting the order of distribution to create these
priorities does not increase the total amount of funds available for creditors.
Rather, it will only result in a benefit to one group of creditors at the expense
of another group. The larger the number of categories of priority creditors, the
greater the scope for other groups to claim that they also deserve priority
treatment. The greater the number of creditors receiving priority treatment, the
less beneficial that treatment becomes.

70. Some of the factors that may be relevant in determining whether compel-
ling reasons exist to grant privileged status to any particular type of debt may
include the need to give effect to international treaty obligations, such as those
applicable to employee claims (discussed further below); the need to strike a
balance between private rights and public interests and the alternative means
available to address those public interests; the desirability of creating incen-
tives for creditors to manage credit efficiently and to fix the price of credit as
low as possible; the impact on transaction and compliance costs; and the
desirability of drawing fine distinctions between creditors that result in one
class of creditor having to bear a greater burden of unpaid debt.

71. Many different approaches are taken to the types of claim that will be
afforded priority and what that priority will be. The types of priority afforded
by States vary, but two categories are particularly prevalent. The first is a
priority for employee salaries and benefits (social security and pension claims)
and the second is for tax claims. Consideration of the priority of tax claims
may be of particular concern in transnational cases. One approach might be
to disallow priority for all foreign tax claims. An alternative might be to
272                                                  UNCITRAL Legislative Guide on Insolvency Law


recognize some type of priority for such tax claims, perhaps limited in scope,
either where there is reciprocity with respect to the recognition of such claims
or where insolvency proceedings in respect of a single debtor are being jointly
administered in more than one state. Article 13 of the UNCITRAL Model
Law on Cross-Border Insolvency recognizes the importance of the non-
discrimination principle with respect to the ranking of foreign claims, but also
provides that States that do not recognize foreign tax and social security claims
can continue to discriminate against them.12

       a.    Employee claims13
72. In a majority of States, workers’ claims (including claims for wages, leave
or holiday pay, allowances for other paid absence and severance pay) consti-
tute a class of priority claims in insolvency. In a number of cases those claims
rank higher than most other priority claims, specifically tax and social security
claims, and in a few cases, as noted above, above secured claims (see paras. 63
and 64). The approach of providing priority for workers’ claims is generally
consistent with the special protection that is afforded to employees in other
areas of insolvency law (see chap. II, para. 145), as well as with the approach
of international treaties on protection of workers.14 In some insolvency laws,
the importance of maintaining continuity of employment in priority to other
objectives of insolvency proceedings, such as maximization of value of the
estate for the benefit of all creditors, is evidenced by a focus on sale of the
business as a going concern (with the transfer of existing employment obliga-
tions), as opposed to liquidation or reorganization where these obligations may
be altered or terminated.

73. In some States, employee claims are afforded priority, but will rank
equally with taxes and social security claims in a single class of priority claims
and may be satisfied proportionately in the event of insufficient funds. In
others, no priority is provided for employee claims and they are ranked as
ordinary unsecured claims, although in some cases payment of certain obliga-
tions accrued over specified periods of time (e.g. wages and remuneration
arising within three months before commencement of insolvency proceedings)
may be guaranteed by the State through a wage guarantee fund or insurance
scheme providing a separate source of funds to ensure the settlement of
employees’ claims. The fund guaranteeing the payment of such claims may
itself have a claim against the estate and may or may not have the same priority

      12
         See the UNCITRAL Model Law on Cross-Border Insolvency, article 13, paragraph 2, and
footnote 2 (see annex III); EC Regulation 1346/2000, article 4.2, subparagraph (i), provides that the
ranking of claims is determined by the law of the State of the opening of the proceedings (whether
main or secondary).
      13
         For an analysis of national laws on the protection of employees’ service-related claims, see the
2003 General Survey on the Application of the Protection of Wages Convention of 1949 (No. 95)
prepared by the International Labour Organization (ILO) Committee of Experts on the Application of
Conventions and Recommendations, paras. 298-353.
      14
         For example, the ILO Protection of Workers’ Claims (Employer’s Insolvency) Convention of
1992 (No. 173). Article 8, paragraph 1, provides that “national laws or regulations shall give workers’
claims a higher rank of privilege than most other privileged claims, and in particular those of the State
and social security system”. The Convention entered into force in 1995.
Part two:      V. Management of proceedings                                   273


vis-à-vis the insolvency estate as the employee claims, depending upon policy
considerations such as the use of public monies (as opposed to the assets of the
insolvent debtor) for funding the provision of wage compensation. Usual
practice would be for the fund to enjoy the same rights as the employee, at
least in respect of a certain specified amount that may be denoted in terms of
an amount of wages or a number of weeks of pay.

         b.     Tax claims
74. Priority is often accorded to government tax claims to protect public
revenue, but has also been justified on a number of other grounds. These
grounds include that it can be beneficial to reorganization because tax authori-
ties will be encouraged to delay the collection of taxes from a troubled busi-
ness on the basis that eventually they will be afforded a priority for payment
under insolvency and that, because the government is a non-commercial and
unwilling creditor, it may be precluded from some commercial debt recovery
options. Providing a priority to such claims, however, can be counterproduc-
tive because failure to collect taxes can compromise the uniform enforcement
of tax laws and may constitute a form of state subsidy that undermines the
discipline that an effective insolvency regime is designed to support. It may
encourage tax authorities to be complacent about monitoring debtors and col-
lecting debts in a commercial manner that otherwise would assist to prevent
insolvency and the depletion of assets (on treatment of foreign tax claims, see
above, para. 10).

   (iv)       Ordinary unsecured creditors
75. Once the claims of all secured and priority creditors have been satisfied,
the balance of the insolvency estate would generally be distributed pro rata to
ordinary unsecured creditors. There may be subdivisions within the class, with
some claims being treated as subordinate or with a priority as noted above.
Some of the types of claim that are generally subordinated are discussed
below.

   (v)        Owners and equity holders
76. Owners and equity holders may have claims arising from loans extended
to the debtor and claims arising from their equity or ownership interest in the
debtor. Many insolvency laws distinguish between these different claims. With
respect to claims arising from equity interests, many insolvency laws adopt the
general rule that the owners and equity holders of the business are not entitled
to a distribution of the proceeds of assets until all other claims that are senior
in priority have been fully repaid (including claims of interest accruing after
commencement). As such, these parties will rarely receive any distribution in
respect of their interest in the debtor. Where a distribution is made, it would
generally be made in accordance with the ranking of shares specified in the
company law and the corporate charter. Debt claims, such as those relating to
loans, however, are not always subordinated.
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   (vi)    Related persons
77. A category of creditors that may require special consideration is that of
persons related to the debtor, whether in a familial or business capacity (see
chap. II, para. 183, and above, para. 48). Under some insolvency laws, these
claims are always subordinated and under other laws they are subordinated
only on the basis of inequitable conduct or fraudulent or quasi-fraudulent
conduct. Where they are subordinated, the claims may rank after ordinary
unsecured claims. Other approaches for treatment of these claims do not relate
to ranking, but to restrictions on voting rights or to the amount or percentage
of the claim that will be admitted in the proceedings.

   (vii)   Fines, penalties and post-commencement interest
78. Some States treat claims such as gratuities and fines and penalties
(whether administrative, criminal or of some other type) as ordinary unsecured
claims and subordinate them to other unsecured claims. In some insolvency
laws these types of claim are treated as excluded claims.

79. Different approaches are taken to the accrual and payment of interest on
claims. Some insolvency laws provide that interest on claims ceases to accrue
on all unsecured debts once liquidation proceedings have commenced, but that
payment in reorganization will depend upon what is agreed in the plan. In
other cases, where provision is made for interest to accrue after commence-
ment of proceedings, payment may be subordinated and it will be paid only
after all other unsecured claims have been paid.




                                 2.   Distribution
(a)   Liquidation
80. Where there are a number of different categories of claims with different
priorities, each level of priority will generally be paid in full before the next
level is paid. Once a level of priority is reached where there are insufficient
funds to pay all the creditors in full, the creditors of that priority share pro rata.
In some laws that do not establish different levels of priority, all the creditors
share pro rata if there are insufficient funds to pay them all in full.

(b)   Reorganization
81. A plan of reorganization may propose distribution priorities that are dif-
ferent to those provided by an insolvency law in liquidation, provided that
creditors voting on the plan approve such a modification. In reorganization
proceedings it may be desirable to provide that priority claims must be paid in
full as a predicate to confirmation of a plan, unless the affected priority credi-
tors agree otherwise.
Part two:    V. Management of proceedings                                                         275




                                Recommendations 185-193

     Purpose of legislative provisions
            The purpose of provisions on priority and distribution is:
          (a) To establish the order in which claims should be satisfied from the
     estate;
         (b) To ensure that similarly ranked creditors are satisfied proportionately
     out of the assets of the estate; and
         (c) To specify limited circumstances in which priority in distribution is
     permitted.

     Contents of legislative provisions
     Classes and treatment of creditors affected by commencement
     of insolvency proceedings
          185. The insolvency law should specify the classes of creditors that will
     be affected by the commencement of insolvency proceedings and the treatment
     of those classes in terms of priority and distribution.

     Establishing an order for satisfaction of claims (paras. 5 and 52)
          186. The insolvency law should establish the order in which claims are
     to be satisfied from the estate.

     Priority claims (paras. 53 and 67-71)
          187. The insolvency law should minimize the priorities accorded to un-
     secured claims. The law should set out clearly the classes of claims, if any,
     that will be entitled to be satisfied in priority in insolvency proceedings.

     Secured claims (paras. 62-65)
          188. The insolvency law should specify that a secured claim should be
     satisfied from the encumbered asset in liquidation or pursuant to a reorganiza-
     tion plan, subject to claims that are superior in priority to the secured claim,
     if any. Claims superior in priority to secured claims should be minimized and
     clearly set forth in the insolvency law. To the extent that the value of the
     encumbered asset is insufficient to satisfy the secured creditor’s claim, the
     secured creditor may participate as an ordinary unsecured creditor.

     Ranking of claims other than secured claims (paras. 66-79)
          189. The insolvency law should specify that claims other than secured
     claims, are ranked in the following order:15
            (a) Administrative costs and expenses;



       15
         The insolvency law may provide for further ranking of claims within each of the ranks set
forth in subparagraphs (a), (b) and (d). Where all creditors within a rank cannot be paid in full, the
order of payment should reflect any further ranking specified in the insolvency law for claims of the
same rank.
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      Recommendations 185-193 (continued)

          (b) Claims with priority;
          (c) Ordinary unsecured claims;
          (d) Deferred claims or claims subordinated under the law.

           190. The insolvency law should specify that in the event there is a sur-
      plus after all claims have been satisfied in full, the surplus is to be returned
      to the debtor.

      Distribution in liquidation (paras. 40 and 80)
           191. The insolvency law should provide, as a general principle, that
      similarly ranked claims are paid pari passu. All similarly ranked claims in a
      particular class should be paid in full before the next rank is paid.

           192. The insolvency law should specify that in making a distribution the
      insolvency representative is to be required to make provision for submitted
      claims that are not yet finally admitted.

            193. The insolvency law should specify that, in liquidation proceedings,
      distributions are to be made promptly and that interim distributions may be made.




            C.     Treatment of corporate groups in insolvency
                                    1.   Introduction
82. It is common practice for commercial ventures to operate through groups
of companies and for each company in the group to have a separate legal
personality. Where a company in a group structure becomes insolvent, treat-
ment of that company as a separate legal personality raises a number of issues
that are generally complex and may often be difficult to address. In certain
situations, such as where the business activity of a company has been directed
or controlled by a related company, the treatment of the group companies as
separate legal personalities may operate unfairly. That treatment, for example,
may prevent access to the funds of one company for the payment of the debts
or liabilities of a related debtor company (except where the debtor company is
a shareholder or creditor of the related company), notwithstanding the close
relationship between the companies and the fact that the related company may
have taken part in the management of the debtor or acted like a director of the
debtor and caused it to incur debts and liabilities. Furthermore, where the
debtor company belongs to a group of companies, it may be difficult to
untangle the specific circumstances of any particular case to determine which
group company particular creditors dealt with or to establish the financial
dealings between group companies.
Part two:   V. Management of proceedings                                      277


83. Three issues of specific concern in insolvency proceedings involving one
of a group of companies are:
     (a) The responsibility of any other company in the group for the external
debts of the insolvent company (being all debts owed by the insolvent com-
pany except for those owed to related group companies, i.e. “intra-group
debts”);
    (b) The treatment of intra-group debts (claims against the debtor
company by related group companies); and
     (c) Commencement of insolvency proceedings by a group company
against a related group company.

84. Reflecting the complexity of this topic, the discussion that follows is
intended only as a brief introduction to some of these issues. Insolvency laws
provide different responses to these and other issues, which may be distin-
guished by the extent to which a law allows the veil of incorporation to be
lifted. Some laws adopt a prescriptive approach, which strictly limits the cir-
cumstances in which group companies can be treated as other than separate
legal personalities and the corporate veil lifted or, in other words, the circum-
stances in which a related company can be responsible for the debts of an
insolvency group member. Other laws adopt a more expansive approach and
give courts broad discretion to evaluate the circumstances of a particular case
on the basis of specific guidelines. The range of possible results in the latter
case is broader than under those laws adopting a prescriptive approach. In
either case, however, it is common for insolvency laws to address these issues
of intra-group liability on the basis of the relationship between the insolvent
and related group companies in terms of both shareholding and management
control. One possible advantage of addressing these issues in an insolvency
law is to provide an incentive for corporate groups to continuously monitor the
activities of companies within the group and take early action in the case of
financial distress of a member of that group. Treating companies as other than
separate legal entities, however, may undermine the capacity of business,
investors and creditors to quarantine, and make choices about, risk (which may
be particularly important where the group includes a company with special
requirements for risk management, such as a financial institution). It may
introduce significant uncertainty that affects the cost of credit, in particular
when the decision about responsibility for group debts is made by a court after
the event of insolvency; and involve accounting complexities concerning the
manner in which liabilities are treated within the group.

85. Although a variety of approaches are taken to these very complex issues,
it is important that an insolvency regime address matters concerning corporate
groups in sufficient procedural detail to provide certainty for all parties con-
cerned in commercial transactions with corporate groups. Alternatives to direct
regulation of corporate groups in insolvency would include providing suffi-
cient definition in other parts of the insolvency law to allow application of
these provisions to corporate groups, such as the use of avoidance or subordi-
nation provisions with respect to related parties.
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                   2.    Group responsibility for external debts
86. Insolvency regimes look to a number of different circumstances or factors
in the assessment of whether a related or group company should bear respon-
sibility for the external debts of an insolvent member of the group.

87. It is common in many jurisdictions for the related company to bear
responsibility for the debt where it has given a guarantee in respect of its
subsidiaries. Similarly, many regimes infer responsibility to compensate for
any loss or damage in cases of fraud in intra-group transactions. Further solu-
tions may be prescribed by other areas of law. In some circumstances, for
example, the law may treat the insolvent company as an agent of the related
company, which would permit third parties to enforce their rights directly
against the related company as a principal.

88. Where the insolvency law grants the courts a wide discretion to determine
the liability of one or more group companies for the debts of other group
companies, subject to certain guidelines, those guidelines may include the
following considerations: the extent to which management, the business and
the finances of the companies are intermingled; the conduct of the related
company towards the creditors of the insolvent company; the expectation of
creditors that they were dealing with one economic entity rather than two or
more group companies; and the extent to which the insolvency is attributable
to the actions of the related group company. Based on these considerations, a
court may decide on the degree to which a corporate group has operated as a
single enterprise and, in some jurisdictions, may order that the assets and
liabilities of the companies be consolidated or pooled,16 in particular where that
order would assist in a reorganization of the corporate group, or that a related
company contribute financially to the insolvent estate, provided that contribu-
tion would not affect the solvency of the contributing company. Contribution
payments would generally be made to the insolvency representative adminis-
tering the insolvent estate for the benefit of the estate as a whole.

89. One further and important consideration in insolvency laws that allow
such measures is the effect of those measures on creditors. These regimes, in
seeking to ensure fairness to creditors as a whole, must reconcile the interests
of two (or more) sets of creditors who have dealt with two (or more) separate
corporate entities. These collective interests will conflict if the total assets of
the combined companies are insufficient to meet all claims. In such a case,
creditors of a group company with a significant asset base would have their
assets diminished by the claims of creditors of another group company with a
low asset base. One approach to this issue is to consider whether the savings
to creditors collectively would outweigh the incidental detriment to individual
creditors. In the situation where both companies are insolvent, some laws take

       16
          A decision that a corporate group has operated as one economic entity will give rise to
application of other provisions of the insolvency law, for example, the duty of directors to prevent
insolvent trading. Some laws also allow, in limited circumstances, companies to voluntarily pool
assets and liabilities.
Part two:   V. Management of proceedings                                                          279


into account whether withholding a consolidation decision, ensuring separate
insolvency proceedings, would increase the cost and length of proceedings and
deplete funds that would otherwise be available for creditors and result in
benefiting the equity holders of some corporate group companies who receive
a return at the expense of creditors in other group companies.17

90. The common principle of all regimes with laws of this type is that, for a
consolidation order to be granted, the court must be satisfied that creditors
would suffer a greater prejudice in the absence of consolidation than the insol-
vent companies and objecting creditors would from its imposition. In the
interests of fairness, some jurisdictions allow for partial consolidation by
exempting the claims of specific creditors and satisfying those claims from
particular assets (excluded from the consolidation order) of one of the insol-
vent companies. The difficulties imposed by this reconciliation exercise have
resulted in such orders being infrequently made in those States where they are
available.

91. It should be noted that insolvency laws providing for consolidation do not
affect the rights of secured creditors, other than possibly the holders of intra-
group securities (where the secured creditor is a group company).

                                   3.    Intra-group debts
92. Intra-group debts may be dealt with in a number of ways. Under some
insolvency laws, intra-group transactions may be subject to avoidance proceed-
ings. Under some insolvency laws that provide for consolidation, intra-group
obligations are terminated by the consolidation order. Other approaches
involve classifying intra-group transactions differently from similar transac-
tions conducted between unrelated parties (e.g. a debt may be treated as an
equity contribution rather than as an intra-group loan), with the consequence
that the intra-group obligation will rank lower in priority than the same
obligation between unrelated parties.




      17
        Some laws require creditors, as well as assets and liabilities, of each relevant group company
to be separately identified before any distribution can be made.
                 VI.     Conclusion of proceedings
                                A.    Discharge
1. There is an increasing awareness in some circles of the need to recognize
business failure as a natural feature of an economy and to accept that both
weak and good businesses can fail, albeit for different reasons, without neces-
sarily involving irresponsible, reckless or dishonest behaviour on the part of
the management of the business. A person who has failed in one business may
have learned from that experience and some studies suggest that they are often
very successful in later business ventures. For these reasons, a number of
States have taken the view that their insolvency regime needs to focus not only
on addressing the administration of failure but also upon facilitating a fresh
start for insolvent debtors by clearing their financial situation and taking other
steps to reduce the stigma associated with business failure rather than upon
punishment of the debtor. In addition to adapting an insolvency law to remove
unnecessary conditions and restrictions on discharge, there is a need to
encourage banks and the wider community to take a different view of business
failure and to provide assistance and support to those involved. At the same
time, the insolvency regime needs to protect the public and the commercial
community from those debtors whose conduct of their financial affairs has
been irresponsible, reckless or dishonest.

2. Following distribution in the liquidation of the insolvency estate, it is
likely that a number of creditors will not have been paid in full. An insolvency
law will need to consider whether those creditors will still have an outstanding
claim against the debtor or, alternatively, whether the debtor will be released
or “discharged” from those residual claims.



                1. Discharge of the debtor in liquidation
(a)   Where the debtor is a legal entity
3. When the debtor is a limited liability company, the question of discharge
following liquidation does not arise; generally the law provides for the disap-
pearance of the legal entity or, alternatively, that it will continue to exist as a
shell with no assets. The equity holders will not be liable for the residual
claims and the issue of their discharge does not arise. If the debtor’s business
takes a different form, such as a sole proprietorship, a group of individuals
(a partnership) or an entity whose owners have unlimited liability, the question
arises as to whether those debtors as individuals will still be personally liable
for unsatisfied claims following liquidation.

                                        281
282                                       UNCITRAL Legislative Guide on Insolvency Law


(b)   Where the debtor is a natural person
4. Insolvency laws adopt a variety of different approaches to the question of
discharge of a natural person debtor. Under some laws an insolvent debtor
cannot be discharged until all its debts are paid. Under other laws, the debtor
remains liable for unsatisfied claims, subject to a limitation period (which in
some cases might be quite long, for example, 10 years), after which a dis-
charge might be given. Some of those laws may also impose on the debtor a
number of conditions and restrictions relating to professional, commercial and
personal activities, for example, acting as the director of a corporation. This
type of rule emphasizes the value of a debtor-creditor relationship: the con-
tinued responsibility of the debtor following liquidation is intended to both
moderate a debtor’s financial behaviour and encourage a creditor to provide
financing. At the same time, it may work to inhibit opportunity, innovation and
entrepreneurial activity, because the sanctions for failure are severe and deter
debtors from applying for commencement of insolvency proceedings.

5. Other insolvency laws provide for a complete discharge of an honest, non-
fraudulent debtor immediately following distribution in liquidation. This
approach emphasizes the benefit of the “fresh start” that discharge brings and
is often designed to encourage the development of an entrepreneurial class. It
is also recognition that over-indebtedness is a current economic reality and
should be addressed by an insolvency law. A third approach attempts to strike
a compromise: discharge is granted after a period following distribution,
during which period the debtor is expected to make a good faith effort to
satisfy its outstanding obligations.

6. Irrespective of the approach adopted, in some circumstances all laws
restrict the availability of a discharge. These circumstances vary from law to
law but may include where the debtor has acted fraudulently; engaged in
criminal activity; violated employment or environmental laws; failed to keep
appropriate records; failed to participate in the insolvency proceedings in good
faith or to cooperate with the insolvency representative; failed to provide or
actively withheld or concealed information; continued trading at a time when
it knew it was insolvent; incurred debts with no reasonable expectation of
being able to pay them; and concealed or destroyed assets or records after the
application for commencement.

7. Certain types of debt may be excluded from the discharge, such as those
arising from tort claims; maintenance agreements (payments to a divorced
spouse or to support children of the debtor); fraud; penalties, where the alter-
native is a term of imprisonment; and taxes.

8. In addition to imposing conditions as part of a discharge, conditions may
also be imposed upon the debtor and its activities during the proceedings and
as a precondition for a discharge. These restrictions may be recommended by
the insolvency representative or by the court. These conditions may include
restrictions on the debtor’s ability to obtain new credit; leave the country; carry
on business for a certain period of time; or practise its profession for a period
Part two: VI. Conclusion of proceedings                                       283


of time. A discharge may also be provided on the condition that the debtor
does not subsequently acquire a substantial new fortune from which previous
debts could be paid. The length of the application of these restrictions varies,
depending upon the situation of the debtor. Other limitations adopted by insol-
vency laws relate to the number of times a debtor can be discharged. In some
jurisdictions, a discharge is a once in a lifetime opportunity; in others there is
a minimum waiting period, for example, 10 years, before a debtor will qualify
for a new discharge or even be able to enter insolvency proceedings that may
lead to a new discharge. A further approach restricts discharge where, for
example, the debtor has been given a discharge within a certain period of time
before commencement of the current proceedings and the payments made in
those previous proceedings were less than a fixed percentage.

9. The choice between these different alternatives involves weighing the
underlying rationale of an insolvency law and the provision of a discharge
against the need to sanction certain behaviour. A distinction might be drawn
between behaviour that is inappropriate and perhaps negligent and behaviour
that would amount to criminal misconduct. If the underlying purpose of the
insolvency law is to resolve the financial difficulties of the debtor and provide
for a fresh start to encourage entrepreneurial activity and risk-taking, an honest
and cooperative debtor that has performed its obligations under the insolvency
law can be discharged after liquidation with minimal restrictions. An approach
that imposes severe restrictions upon such debtors and allows a discharge only
after long periods of time and the fulfilment of many conditions suggests that
the underlying purpose is to punish, rather than rehabilitate the debtor. Impos-
ing conditions and restrictions might be more appropriate in cases where the
debtor has not been honest, has not cooperated with the insolvency representa-
tive or performed its obligations under the insolvency law or, in more extreme
cases, has been guilty of criminal misconduct.

10. An additional consideration in framing the conditions for discharge is the
connection between those conditions and the basic rationale of discharge. The
imposition of certain broad conditions, such as prohibiting the debtor generally
from engaging in business activities, may operate as a sanction and be incon-
sistent with the basic notion of providing a fresh start. More specific condi-
tions, such as limiting the debtor’s ability to serve on a board of directors
might be more appropriate, especially where the debtor was a director of the
business that became insolvent. Where an insolvency law adopts the approach
of imposing conditions and exempting certain debts from